UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-K





(Mark
one)





[X]
            Annual
      Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934 for the fiscal year ended December 31, 2007,
  or





[   ]
            Transition
      Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934 for the transition period from ______________ to
      _____________.





Commission
File No. 0-23862


Fonix
Corporation


(Exact
name of registrant as specified in its charter)





Delaware
              (State
      or other jurisdiction of incorporation or organization)
            22-2994719
              (I.R.S.  Employer
      Identification No.)





9350
South 150 East, Suite 700


Sandy,
Utah 84070


(Address
of principal executive offices with zip code)





(801)
553-6600


(Registrant's
telephone number, including area code)





Securities
      registered pursuant to Section 12(b) of the Act:
            None





Securities
      registered pursuant to Section 12(g) of the Act:
            Class
      A Common Stock ($0.0001 par value per
share)





Indicate
by check mark if the registrant is a well-know seasoned issuer, as defined in
Rule 405 of the Securities Act


Yes
[  ] No [X]





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d)


Required
[X] Not Required [  ]





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days: Yes [X] No[  ].





The
aggregate market value of the voting stock held by non-affiliates of the
registrant as of June 30, 2007 was approximately $2,094,000, calculated using a
closing price of $0.0009 per share on June 30, 2007.  For purposes of
this calculation, the registrant has included only the number of shares directly
held by its officers and directors as of (and not counting shares beneficially
owned on that date), in determining the shares held by
non-affiliates.





As of
March 31, 2008, there were issued and outstanding 5,752,687,745 shares of our
Class A common stock.





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of the registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  [  ]





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer, or a smaller reporting
company.  See definition of “accelerated filer and large accelerated
filer,”  and “smaller reporting company” in Rule 12b-2 of the Exchange
Act.  (Check one):


Large
accelerated filer [  ]  Accelerated filer
[  ]  Non-accelerated filer
[  ]  Smaller reporting company [X]





Indicate
by check mark whether the registrant is a shell company (as defined in rule
12b-2 of the Exchange Act).  Yes [  ]  No
[X].











Fonix
Corporation





2007 FORM
10-K ANNUAL REPORT








TABLE OF
CONTENTS





Part
      IPageItem
      1.
            Business
            3Item
      1A.
            Risk
      Factors
            9Item
      2.
            Properties
            18Item
      3.
            Legal
      Proceedings
            18Item
      4.
            Submission
      of Matters to a Vote of Security Holders
            19Part
      IIItem
      5.
            Market
      for Registrant's Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
            19Item
      6.
            Selected
      Financial Data
            24Item
      7.
            Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
            26Item
      7A.
            Quantitative
      and Qualitative Disclosures About Market Risk
            41Item
      8.
            Financial
      Statements and Supplementary Data
            41Item
      9A.
            Controls
      and Procedures
            42Part
      IIIItem
      10.
            Directors,
      Executive Officers and Corporate Governance
            43Item
      11.
            Executive
      Compensation
            44Item
      12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
            50Item
      13.
            Certain
      Relationships and Related Transactions, and Director
      Independence
            50Item
      14.
            Principal
      Accountant Fees and Services
            51Part
      IVItem
      15.
            Exhibits
      and Financial Statement Schedules
            52

















PART
I





ITEM
      1.
            BUSINESS





THIS
ANNUAL REPORT ON FORM 10-K CONTAINS, IN ADDITION TO HISTORICAL INFORMATION,
FORWARD-LOOKING STATEMENTS THAT INVOLVE SUBSTANTIAL RISKS AND
UNCERTAINTIES.  OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE
RESULTS ANTICIPATED BY FONIX AND DISCUSSED IN THE FORWARD-LOOKING
STATEMENTS.  FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH
DIFFERENCES ARE DISCUSSED BELOW IN THE SECTION “MANAGEMENT’S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS,” IN THE SECTION
ENTITLED “FORWARD-LOOKING STATEMENTS,” AND ELSEWHERE IN THIS ANNUAL
REPORT.  WE DISCLAIM ANY INTENTION OR OBLIGATION TO UPDATE OR REVISE
ANY FORWARD-LOOKING STATEMENT, WHETHER AS A RESULTOF NEW INFORMATION, FUTURE
EVENTS, OR OTHERWISE.  THE FOLLOWING DISCUSSION SHOULD BE READ
TOGETHER WITH OUR FINANCIAL STATEMENTS AND RELATED NOTES THERETO INCLUDED
ELSEWHERE IN THIS DOCUMENT.





About
Fonix





Fonix
Corporation (the “Company,” “Fonix,” or “we”) is engaged in providing
value-added speech technologies through our subsidiary, Fonix Speech, Inc.
(“Fonix Speech”). We offer speech-enabling technologies including automated
speech recognition (“ASR”) and text-to-speech (“TTS”) through Fonix Speech. We
offer our speech-enabling technologies to markets for personal software for
consumer applications including video games, e.Dictionaries and mobile
navigation devices with GPS, wireless and mobile devices, computer telephony,
and server solutions. We have received various patents for certain elements of
our core technologies and have filed applications for other patents covering
various aspects of our technologies. We seek to develop relationships and
strategic alliances with third-party developers and vendors in
telecommunications, computers, electronic devices and related industries,
including producers of application software, operating systems, computers and
microprocessor chips. Revenues are generated through licensing of
speech-enabling technologies, unit royalties, maintenance contracts and
services.





We are
continually developing new product offerings utilizing our TTS and ASR
technologies in an effort to increase our revenue stream, and we are continuing
to work with our existing customers to increase sales. We have also experienced
operating expense decreases through headcount reductions and overall cost
reduction measures. Through the combination of increased recurring revenues and
implemented operating cost reduction strategies, we hope to achieve positive
cash flow from operations in the next 18-24 months. However, there can be no
assurance that we will be able to achieve positive cash flow from operations
within this time frame.





Our cash
resources, limited to loans, collections from customers and sales of our
equity and debt securities, have not been sufficient to cover operating
expenses.  We periodically engage in discussions with various sources of
financing to facilitate our cash requirements including buyers of both debt and
equity securities. To date, no additional sources of funding offering terms
superior to those available under equity lines and convertible debentures have
been implemented, and we rely on, first, cash generated from operations and
second, convertible debt financing arrangements.  In addition to
anticipated revenues generated from current and future customers, we will need
to generate approximately $2 to $3 million to continue operations for the next
twelve months.  There can be no assurance that we will be able to
obtain such financing or that the terms will be favorable to the
Company.





We
previously operated a telecommunications business, the results of which were
included in prior SEC filings. On October 2, 2006, LecStar Telecom Inc., a
Georgia corporation (“LecStar Telecom”), LecStar DataNet, Inc., a Georgia
corporation (“LecStar DataNet”), LTEL Holdings Corporation (“LTEL Holdings”), a
Delaware corporation, and Fonix Telecom Inc., a Delaware corporation (“Fonix
Telecom”), each of which are direct or indirect subsidiaries of Fonix, filed for
bankruptcy protection in the United States Bankruptcy Court for the District of
Delaware (the “Bankruptcy Court”). The case numbers are as follows: LTEL
Holdings Corporation, 06-11081 (BLS); LecStar Telecom, Inc., 06-11082 (BLS);
LecStar DataNet, Inc., 06-11083 (BLS); Fonix Telecom, Inc., 06-11084
(BLS).)








3





LecStar
Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom sought protection
under Chapter 7 of title 11 of the U.S. Bankruptcy Code, 11 U.S.C ss 101 et seq.
(the “Bankruptcy Code”). Pursuant to Bankruptcy Code Section 701, on October 3,
2006, Alfred Thomas Guliano was appointed the interim trustee for LecStar
Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom. As these subsidiary
companies were in Chapter 7 Bankruptcy proceedings as of the date of this Annual
Report, the results of their operations have been treated as discontinued
operations.





Company
Internet addresses are as follows:


Fonix
Corporation – www.fonix.com


Fonix
Speech, Inc. – www.fonixspeech.com





History and Development of
the Company





The
Company was incorporated in Delaware in 1985, and, pursuant to a merger
transaction in 1994, the Company’s name was changed to Fonix
Corporation.  Through Fonix Speech, the Company delivers speech
interface development tools, solutions and applications (the “Speech Products”)
that empower people to interact conversationally with information systems and
devices.  The Speech Products are based on the Company’s
speech-enabling technologies, which include TTS and proprietary neural
network-based automatic speech recognition (“ASR”).  ASR and TTS
technologies are sometimes collectively referred to as our “Core
Technologies.”  The Company’s Speech Products enhance user
productivity, ease of use and efficiency in a broad range of market segments,
including mobile and wireless devices; videogame consoles; electronic devices
for the assistive and language learning markets, robots, appliances; automotive
telematics, computer telephony and server applications.





Prior to
2002, the Company focused on research and development (“R&D”) projects for
customized applications.  R&D and prototype development used the
Core Technologies to develop applications and engines marketed for multiple
operating systems and hardware platforms.





Today,
Fonix Speech serves markets that are adopting speech-enabled interfaces,
solutions and applications.  As memory requirements, noise robustness,
speech recognition accuracy and efficiency of speech interface solutions become
increasingly critical, Fonix Speech anticipates that its Core Technologies and
solutions will meet customer demand for simple, convenient user
interfaces.





On
February 24, 2004, the Company completed its acquisition of all of the capital
stock of LTEL Holdings Corporation (“LTEL”) and its wholly owned subsidiaries,
LecStar Telecom, Inc. and LecStar DataNet, Inc. (collectively
“LecStar”).  LecStar, an Atlanta-based competitive local exchange
carrier, offered wire line voice, data, long distance and Internet services to
business and residential customers throughout BellSouth’s Southeastern United
States operating territory.  On October 2, 2006, LecStar Telecom,
LecStar DataNet,  LTEL Holdings, and Fonix Telecom, each of which are
direct or indirect subsidiaries of Fonix, filed for bankruptcy protection in the
United States Bankruptcy Court for the District of Delaware, as discussed
above.





VALUE-ADDED
SPEECH TECHNOLOGIES





Fonix Speech,
Inc.





On
January 1, 2006, Fonix Speech, was incorporated and now operates as a wholly
owned subsidiary of Fonix Corporation.  Fonix Speech provides
value-added embedded speech technology development tools, applications and
solutions for multiple market segments comprising mobile and wireless devices,
video game consoles, electronic devices for the assistive and language learning
markets, robots, appliances, automotive telematics, computer telephony and
server applications.





Original
Equipment Manufacturers (“OEMs”) or Original Design Manufacturers (“ODMs”) of
consumer electronics devices and products, software developers, wireless
operators, telephony distributors, system integrators and value-added resellers
(“VARs”) can simplify the use and increase the functionality of their electronic
products and services by integrating Fonix speech interfaces, resulting in
broader market opportunities and significant competitive
advantages.  Fonix Speech development tools and solutions support
multiple hardware and software platforms, are environment and speaker
independent, optimize cost and power efficiencies, are easily integrated with
relatively small memory requirements for embedded applications, and enhance
scalability for high channel capacity for computer telephony and server-based
systems.








4





Fonix
Speech Market Focus





Fonix
Speech delivers speech solutions in the following markets:





§
            Electronic
      Devices


Fonix
speech solutions make everyday life easier for people who are blind or have
visual, vocal or mobility impairments, and for non-English speakers who are
learning the English language.  FonixTalk® and  Fonix
DECtalk®, recognized TTS technology for the assistive market, transforms
ordinary text into highly intelligible speech.  Fonix VoiceInTM is
Fonix Speech’s proprietary neural network-based ASR technology.  Fonix
Speech has taken its intuitive Core Technologies and applied them to everyday
speech solutions for PCs and other consumer devices such as cordless phones,
electronic dictionaries, MP3s and toys.




Fonix Speech Solutions for
Electronic Devices





Fonix
Speech offers a variety of speech solutions for the assistive and language
learning markets.





o
            The Assistive
      Market


Fonix
speech solutions make everyday life easier for people who are blind, have
visual, vocal or mobility impairments or have learning
disabilities.  Fonix DECtalk is the assistive industry’s premier
text-to-speech engine, offering nine highly intelligible TTS voices and six
languages.  Many users rely on Fonix DECtalk to read their email, the
daily news or other documents, or to function as their voice to the outside
world.  Current OEM partners in the assistive market include Dynavox,
GW Micro, Prentke-Romich, Kurzweil Education Systems and Toby
Churchill.




o
            PDA, PC and Electronic
      Devices


Fonix
solutions apply speech interfaces to tasks that users perform
everyday.  Many of these solutions are appropriate for multiple
markets — assistive, mobile and wireless, and business and home
users.  The Speech Products enable users to listen to documents, have
email read aloud, access programs and launch applications with speech
commands.  Current partners include Microsoft, Intel, Hitachi, O2,
Code Factory, Casio and HTC.





o
            The Language Learning Market –
      e.Dictionaries


Fonix
Speech solutions are particularly useful for non-English speakers who are
learning the language.  In the speech-enabled language learning (also
known as “language acquisition” ) market, Fonix has capitalized on (i)
FonixTalk and Fonix DECTalk’s small memory footprint and high intelligibility
and (ii) Fonix VoiceIn’s high-recognition-rate
capabilities.  Speech-enabled language learning is an emerging market,
especially in Asia.  Multiple OEMs currently sell handheld electronic
dictionaries in Japan and Korea that allow individuals to type a word in their
native language (like Japanese) and have the word read or spoken back to them in
English.  Non-English speakers can look up words in an English
dictionary and have the device speak the word correctly in
English.  Educational electronic dictionary devices are growing in
popularity in Japan and are expected to exceed a market volume of more than
500,000 units per quarter.  Fonix Speech’s goal is to become the
primary supplier of speech solutions for OEMs providing language learning
devices and systems.  Fonix Speech has partnered with Epson and other
chip manufacturers to provide an integrated solution including Fonix speech
technology. Current OEMs marketing e.Dictionary devices featuring Fonix
technology include Casio, Casio Soft, Canon, Huapu, Seiko Instruments, Inventec
Besta, AOne Pro and Brilliant Systems.





Speech
applications are also becoming increasingly popular for day-to-day
use.  Fonix Speech is working with OEM partners to capitalize on
market opportunities for toys, appliances and other devices where speech
applications may be applicable.  Fonix Speech has partnered with Epson
to provide an integrated chip with Fonix speech technology to various OEMs
manufacturing toys and appliances.




Fonix
Speech’s primary competitors in the electronic device markets include Nuance,
Voice Signal, Premier Assistive Technology and others.








§
            Video Game
      Consoles


Fonix
VoiceIn®Game Edition is Fonix Speech’s award-winning software solution for voice
command and control in Xbox, Xbox 360, PlayStation2, PlayStation3 and PC video
games.  We believe that Fonix VoiceIn is the industry’s most
memory-efficient voice interface.  Game developers worldwide can now
build games that utilize a common version across Xbox, Xbox 360, PlayStation2,
PlayStation3 and PC platforms.  In 2006, Fonix added specialized tools
for game developers including Fonix VoiceIn Karaoke Edition and Fonix VoiceIn
Phonetic Edition. Fonix VoiceIn is optimized for game development where memory
and processing power are at a premium.





Fonix Speech Video Game
Solutions





Fonix
Speech’s voice command software is available for cross-platform game developers
who wish to employ speech interfaces in videogames.  In March 2004,
Fonix Speech made Fonix VoiceIn Game Edition commercially available to
developers that produce videogames on multiple gaming
platforms.  Fonix voice command technology has been available in the
Microsoft Xbox developer’s kit (XDK) since February 2003.  In May
2005, Fonix announced a continuation of its agreement with Microsoft to deliver
Fonix VoiceIn in the new Microsoft Xbox 360 developer’s
kit.  Cross-platform game developers can use the same voice command
software for PlayStation2, PlayStation3 and PC games.  Game developers
worldwide can now build games that utilize a common application program
interface across Xbox, Xbox 360, PlayStation2, PlayStation3 and PC
platforms.  Fonix VoiceIn voice command software is available to game
developers in multiple languages, including English and UK English, German,
French, Spanish, Japanese and Italian.  Currently, Fonix VoiceIn is
included on more than 20 video game titles on retail shelves.





Fonix Speech Video Game
Market Opportunities





In the
video games market, Fonix VoiceIn® Game Edition is a compelling feature for
today’s game developers.  Gamers seek enhancements that add
excitement, interaction and realism.  Fonix VoiceIn allows developers
to take voice command and control to a new level.  The product gives
players new access to games features, command and control functions and menu
navigation.  Fonix expects this exciting new interface to expand
market demand for videogames.




Fonix
VoiceIn Karaoke Edition is a new Fonix speech solution specifically designed for
karaoke game developers. Fonix technology compares the timing, pitch and voice
of the karaoke singer to the reference song and reports on the accuracy of the
karaoke singing. Karaoke singers can better enjoy the experience, and improve
future performances, by accurately measuring their talent against a professional
song track.






Fonix
VoiceIn Phonetic Edition is a new Fonix technology for videogame developers and
animators. Fonix VoiceInPE speech technology
aligns word phonetics with audio data, allowing animators to more precisely
synchronize an animated characters’ facial movements with the phonetic
components of speech. The technology utilizes input text to break down the
phonetic components of words. The result is more realistic facial movement as
animated characters “speak.”




Fonix
Speech’s competitor in the video game market is primarily
Nuance,  Fonix Speech’s partners also have competitors.  For
example, Intel competes with IBM and Epson.  However, Fonix Speech is
not precluded from working with its partners’ competitors.





§
            Mobile /
      Wireless


Fonix
Speech provides embedded speech interface solutions for mobile phones,
Smartphones, PDAs and wireless communication devices.  The
award-winning Fonix VoiceDialTM is a totally interactive, hands-free software
application that enables users to place calls and navigate device menus and
applications simply by speaking.  Fonix VoiceCentralTM is a hands-free
software application for Pocket PC that allows users to access Personal
Information Management (“PIM”) tools, navigate through the device software, and
access song and movie lists simply by speaking.





Fonix Mobile/Wireless
Solutions:








5





o
            Fonix
      VoiceDial


Fonix
VoiceDialis a
totally interactive, hands-free software application for Windows Mobile Pocket
PC, Smartphone and Symbian devices that enables users to access mobile phone
contacts simply by speaking.  VoiceDial is speaker independent, so no
voice training is involved, including both contact names and digit
dialing.  Fonix speech recognition is highly accurate, even in noisy
environments like cars or airports.  VoiceDial offers several
prompting voices; users choose which voices to download to their
device.  All TTS voices are highly intelligible and will handle an
unlimited vocabulary, even with difficult contact names.  VoiceDial is
available in multiple languages — English, French, German and
Spanish.  Current phones supported by Fonix VoiceDial include:
Cingular (now AT&T Wireless) 2125, T-Mobile SDA, SDA II, Audiovox SMT 5600,
i-mate SP3, i-mate SP3i, i-mate SP5, Motorola i930, Motorola MPx220, SPV C500,
SPV C600, TSM 520, T-Mobile MDA, Cingular 8125, PPC 6700, Audiovox PPC 6600,
i-mate PDA2k, i-mate JASJAR, i-mate K-JAM, MDA Pro, SPV M5000, and Qtek
9100.





o
            Fonix
      VoiceCentral


Fonix
VoiceCentral is a totally interactive, hands-free software application for
Windows Mobile Pocket PC and Smartphone devices that enables users to access PIM
tools, navigate through the device software and access song and movie lists
simply by speaking.  VoiceCentral incorporates the award-winning Fonix
VoiceDial software, while adding several other significant
capabilities.  VoiceCentral allows users to manage email (listen to
email, then choose to delete, reply with a .wav file or save); access calendar
and tasks; launch or close any application simply by speaking; dial names
directly from the contact list (users do not have to navigate multiple menu
trees; they just say the name of the person they want to call); and dial a
number directly using a continuous string of numbers.







Fonix Mobile / Wireless
Market Opportunities:





Fonix
Speech’s partners, OEMs and ODMs provide significant potential to reach users in
many market areas.  Fonix Speech has already seen significant market
response to VoiceDial and expects to deliver in the following
channels:





o
            OEMs & ODMs: The
      first Fonix VoiceDial contract delivered the solution on the Hewlett
      Packard (HP) Journada ® 928 WDA.  To date, VoiceDial has shipped
      with these additional devices: Hitachi G1000, i-mate PDA2k, T-Mobile MDA
      III and the O2 XDA IIs.  Fonix also has partnerships with
      Microsoft, Intel, Texas Instruments, Hitachi, O2 and HTC and is
      aggressively pursuing additional OEM opportunities with Nokia, Motorola,
      Sony-Ericsson, Siemens, Palm and
Samsung.





o
            Mobile Operators: Fonix
      markets VoiceDial and VoiceCentral through mobile operators such as
      AT&T Wireless (formerly Cingular), T-Mobile, Orange, Vodafone and
      Verizon. VoiceDial can be delivered several ways, including loading
      software directly on the device or over-the-air
  activation.





o
            Bundled Solutions: Other
      complementary solutions are also channels for distribution for the Speech
      Products. Companies like ALK CodeFactory have integrated Fonix
      Speech’s solutions into their applications.  Fonix Speech
      foresees partners shipping the full VoiceDial and VoiceCentral
      functionality as a complement to their applications and
      devices.





Fonix
Speech has several competitors offering a variety of speech technologies and
products.  Companies like Nuance, Voice Signal and Neuvoice deliver
speaker-dependent and speaker-independent solutions.  Other speech
companies like IBM may introduce competitive products.





§
            Customer Self-Service Solutions
      for Computer Telephony


Fonix
ConnectMeTM is an innovative solution for computer telephony integration and
server systems.  Fonix ConnectMe is a voice-automated telephone
operator that provides anefficient, professional
means of routing incoming, outgoing and internal calls.  Fonix also
offers a voice interface solution for 511 system integrators.  511 is
the designated three-digit phone number for national travel information within
the United States.  Fonix ASR and TTS products are designed to give
developers easy-to-use tools with which to build call center speech enabled
solutions that lower costs and increase customer satisfaction.














Fonix Speech Customer
Self-Service Solutions





Fonix
Speech provides telephony and server-based solutions for automated phone
directory and database information systems.  Fonix Speech believes
that traditional operator systems and other means of accessing information are
becoming antiquated.  Significant time is lost trying to access
information through keypad directories or because calls are blocked after
hours.  Also, information stored or transferred through servers, PBXs
or databases may not easily be accessed through non-integrated
platforms.  Voice-automated systems are capable of integrating these
platforms and meeting customer expectations of competitive costs, easy
installation with minimal change to their existing infrastructure and a simple
user interface.





o
            Fonix ConnectMe


Fonix
ConnectMe is a voice-automated telephone operator that provides an efficient,
professional means of routing incoming, outgoing and internal
calls.  Customers and employees dial one number, speak the name of a
person or a department and are quickly connected to the person or department
they want to reach.  Whether during peak business hours or late at
night, ConnectMe’s 24-hour high-tech customer service capabilities ensure that
all calls reach their intended destinations.  ConnectMe handles all
incoming calls simultaneously, so callers are never put on
hold.  Employees can create, maintain and access their own phone lists
and can customize the delivery of calls.





o
            511 Traffic Information
      System


In July
2000, the FCC assigned “511” as the number for nationwide access to traveler
information. 511 was designated as a free service and when fully implemented
will cover the majority of roads in the U.S., helping travelers avoid congested
routes and safety hazards.  By dialing 5-1-1, callers can access
information about route-specific weather and road conditions.  Fonix
and partner Meridian Environmental Technology, Inc. provide a 511 system in
North Dakota, South Dakota, Nebraska, Kansas and Montana.  Other
states are scheduled to deploy the system in the near
future.  Competition in the 511 market includes TellMe and IBM’s
WebSphere





Fonix Speech Customer
      Self-Service Market
Opportunities





Fonix
Speech is well positioned to be a primary competitor in telephony products with
ConnectMe.  Benefits of ConnectMe include increased customer
satisfaction, immediate ROI, user convenience, easy installation and
maintenance, and its ability to bring a professional “voice” to companies’
telephone operator systems.  Fonix Speech’s market strategy is to sell
ConnectMe through VARs and distributors.  Potential competitors in the
telephony/server market include Nuance and Avaya.




Fonix
Speech Marketing and Sales Activities







Fonix
Speech expects to expand sales through partners, OEMs, ODMs, VARs, direct sales
and existing sales channels, both domestically and
internationally.  Fonix Speech will focus on wireless and mobile
devices, telephony and server phone solutions, assistive and language learning
devices, the videogame market, robots and appliances.





To
address global opportunities, Fonix Speech plans to develop and expand sales and
marketing teams in Asia, Europe and the United States.  Fonix has
partnered with companies like A.I. Corporation, a high-tech Japanese product
distributor and engineering company specializing in embedded system software, to
capitalize on sales and marketing efforts outside the United
States.





Fonix
Speech Strategic Relationships





Fonix
Speech currently has a number of strategic collaboration, distribution and
marketing arrangements with OEMs, software developers and VARs.  Fonix
Speech intends to expand such relationships and add similar relationships,
specifically in markets related to wireless and mobile devices, assistive and
language learning devices and customer self-service solutions.  When
Fonix Speech identifies “first mover” speech-enabling applications that can
integrate Fonix Speech Products and Core Technologies, Fonix Speech intends to
investigate investment opportunities to obtain preferred or priority
collaboration rights.











6





Fonix
Speech Continued Development





Fonix
Speech plans to continue to invest resources in the development and acquisition
of standard speech solutions and enhancements to its Core Technologies,
developer tools and development frameworks to maintain competitive
advantages.





Fonix
Speech Platforms, Ports, and Processors





Fonix
Speech supports multiple microprocessors ("Chips"); including Win32, WinCE, QNX,
Linux, Solaris Palm, Apple OS 10+, Symbian Nokia Series 60 (operating
systems).  Supported operating systems (“OSs”) (these are the chips)
include: Analog Devices’ Blackfin, ARM 7, ARM 9, Epson S1C33 Family, Renesas,
Intel, MIPS, Motorola, NeoMagic’s MiMagic3, MiMagic5, TI OMAP1510, Sun Sparc,
FreeScale iMXL, Samsung S3C, FreeScale mCore and Power PC.





Types
      of Microprocessors
            Types
      of Operating SystemsWin32
            WinCE
            QNX
            Linux
            Solaris
            Apple
      OS 10+
            Symbian
      Nokia Series 60
            No
      OS Support RequiredAnalog
      Devices
              Blackfin
            
            
            
            
            
            
            
            XARM
      7
              ARM
      9
            
            X
              X
            
            X
            
            
            X
            XEpson
              S1C33
      Family
            
            
            
            
            
            
            
            XRenasas
              SH-3
              SH-4
            
            X
              X
            X
            
            
            
            
            XIntel
              SA-1110
              XScale
              X86
            X
            X
              X
            X
              X
            X
              XMIPS
              MIPS
      R4XXX
            
            XMotorola
              PPC
      5100/5200
            
            
            X
            XNeoMagic
              MiMagic3
      (NMS7210)
              MiMagic5
            
            XTI
      OMAP1510 (ARM core)
            
            XSun
      Sparc
            
            
            
            
            XFreescale
      iMXL (ARM)
            
            XSamsung
      S3C ARM
            
            XFreeScale
      mCore
            
            
            
            
            
            
            
            XPower
      PC
            
            
            
            
            
            X





7





RECENT
DEVELOPMENTS





The
Breckenridge Fund LLC – Amended Settlement Agreement





In
February 2008, the Company entered into an amended settlement agreement with The
Breckenridge Fund LLC (“Breckenridge”) under which the Company agreed to pay
Breckenridge $540,000.  The Company has paid Breckenridge $242,500 and
is obligated to pay the balance of $297,500 at the rate of $42,500 per
month.





Investment
Transaction





Between
December 31, 2007 and March 31, 2008, the Company received an aggregate of
$250,000 from two investors in connection with an investment in the
Company.  The Company and the investors are negotiating the terms of the
investment, which will be disclosed once the terms have been finalized and
documents have been signed.





Resignations
of Thomas A. Murdock and William A. Maasberg, Jr.





On Wednesday, March 5, 2008, Thomas A.
Murdock resigned as Chairman of the Board, President, and Chief Executive
Officer of the Company.  Additionally, Mr. Murdock resigned all
officer and director positions he held with Fonix Speech, Inc., Fonix/AcuVoice,
Inc., Fonix/Papyrus Corporation, Fonix UK, Ltd., and Fonix Sales, Korea Group,
Ltd., all subsidiaries of the Company.





Additionally, William A. Maasberg
resigned as director of the Company on Wednesday, March 5, 2008, and as Chief
Operating Officer on March 31, 2008.





Appointment
of New Chairman, President, and Chief Executive Officer





In connection with the resignation of
Messrs. Murdock and Maasberg, the Company appointed Roger D. Dudley, who was
serving as the Company’s Executive Vice President and Chief Financial Officer,
as the Company’s Chairman, President, and Chief Executive
Officer.  Mr. Dudley will continue to serve as Chief Financial
Officer.  Following the resignations of Messrs. Murdock and Maasberg,
Mr. Dudley is the sole director of the Company.





8





ITEM
      1A.
            RISK
      FACTORS





The
short- and long-term success of Fonix is subject to certain risks, many of which
are substantial in nature and outside the control of Fonix.  You
should consider carefully the following risk factors, in addition to other
information contained herein.  When used in this Report, words such as
“believes,” “expects,” “intends,” “plans,” “anticipates,” “estimates,” and
similar expressions are intended to identify forward-looking statements,
although there may be certain forward-looking statements not accompanied by such
expressions.  Additionally, statements that relate to future business
development, financial projections, capital raising, capital requirements,
growth of markets or customer bases, or future business combinations may also
include forward-looking statements.  You should understand that
several factors govern whether any forward-looking statement contained herein
will or can be achieved.  Any one of those factors could cause actual
results to differ materially from those projected herein.  These
forward-looking statements include plans and objectives of management for future
operations, including the strategies, plans and objectives relating to the
products and the future economic performance of Fonix and its subsidiaries
discussed above.  In light of the significant uncertainties inherent
in the forward-looking statements included herein, the inclusion of any such
statement should not be regarded as a representation by Fonix or any other
person that the objectives or plans of Fonix will be achieved.  Fonix
disclaims any intention or obligation to update any forward-looking statement
contained herein.





Our
substantial and continuing losses since inception, coupled with significant
ongoing operating expenses, raise doubt about our ability to continue as a going
concern.





Since
inception, we have sustained substantial losses. Such losses continue due to
ongoing operating expenses and a lack of revenues sufficient to offset operating
expenses. We have raised capital to fund ongoing operations by private sales of
our securities, some of which sales have been highly dilutive and involve
considerable expense. In our present circumstances, there is substantial doubt
about our ability to continue as a going concern absent significant sales of our
products and telecommunication services, substantial revenues from new licensing
or co-development contracts, or continuing large sales of our
securities.





We had
net income of $14,959,000 for December 31, 2007, and net losses $21,943,000 and
$22,631,000 for the years ended December 31, 2006 and 2005, respectively. As of
December 31, 2007, we had an accumulated deficit of $277,943,000, negative
working capital of $34,384,000, derivative liabilities of $20,742,000 related to
the issuance of Series L Preferred Stock,  Series M Preferred Stock,
Series N Preferred Stock,  Series E Convertible Debentures and Series
B Preferred Stock of our subsidiary, accrued liabilities and accrued settlement
obligation of $5,045,000, accounts payable of $1,532,000 and current portion of
notes payable of $3,833,000, Series E debentures of $1,754,000 and deferred
revenues of $445,000.





We expect
to continue to spend significant amounts to enhance our Speech Products and
technologies and fund further Product development. As a result, we will need to
generate significant additional revenue to achieve profitability. Even if we do
achieve profitability, we may not be able to sustain or increase profitability
on a quarterly or annual basis. If we do not achieve and maintain profitability,
the market price for our common stock may further decline, perhaps
substantially, and we may have to curtail or cease our operations.





Continuing
debt obligations could impair our ability to continue as a going
concern.





As of
December 31, 2007, we had debt obligations of $8,291,000, accrued liabilities
and accrued settlement obligation of $5,045,000 and vendor accounts payable of
approximately $1,532,000. At present, our revenues from existing licensing
arrangements and Speech Product sales are not sufficient to offset our ongoing
operating expenses or to pay in full our current debt obligations.





There is
substantial risk, therefore, that the existence and extent of the debt
obligations described above could adversely affect our business, operations and
financial condition, and we may be forced to curtail our operations, sell part
or all of our assets, or seek protection under bankruptcy laws. Additionally,
there is substantial risk that the current or former employees or our vendors
could bring lawsuits to collect the unpaid amounts. In the event of lawsuits of
this type, if we are unable to negotiate settlements or satisfy our obligations,
we could be forced into bankruptcy.








9





The
Breckenridge Judgment for $1,602,000 could impair our ability to continue as a
going concern.





On March 15, 2007, the New York State
trial court entered a judgment against us for $1,602,000 and in favor of the
Breckenridge Fund (the “Breckenridge Judgment”).  The judgment arises
out of our failure to pay the balance due under a settlement agreement with
Breckenridge entered into in September 2005.





The Company does not have cash
sufficient to pay the Breckenridge Judgment.  The Company presently
does not have resources to acquire cash to pay the Breckenridge
Judgment.  However, we have entered into a settlement agreement to pay
the balance due Breckenridge under the Breckenridge Judgment of $297,500 at the
rate of $42,500 for seven consecutive months.  As of the date of this
report the balance owed was $255,000.





If the Company continues to be unable
to obtain resources sufficient to pay the Breckenridge Judgment, or a lesser
amount agreed to as a result of further settlement discussions, Breckenridge
could attempt to collect the balance due under the Breckenridge Judgment by
attaching and executing on property of the Company, subject to existing security
interests.  Such collection activity could be disruptive to the
Company’s business and future prospects.  Management may have to
devote considerable time to defending against Breckenridge collection
activities.  There is substantial risk, therefore, that the existence
of the Breckenridge Judgment and all collection activity arising in connection
with the judgment could adversely affect our business, operations and financial
condition and we may be forced to curtail our operations, sell part or all of
our assets or seek protection under bankruptcy laws.





We
currently do not have access to an equity line facility, which could have a
material adverse effect on our ability to continue operations.





Between 2000 and 2006, we relied
substantially on equity lines of credit for financing our operations. Pursuant
to these equity lines, we historically have drawn funds against the equity line
and put shares of our Class A common stock to the equity line investor in
repayment of the draws. In light of current SEC regulations and interpretations
by the SEC, we terminated the Seventh Equity Line in January 2007 and as of the
date of this Report, we did not have access to an equity line of credit or
similar financing arrangements. Although we are seeking to negotiate additional
financing sources and reviewing our options, there can be no guarantee that we
will be able to enter into arrangements for financing that will be on terms that
will be satisfactory to us. Any inability to enter into new financing
arrangements could have a material adverse impact on our ability to continue our
operations, and we may be required to seek protection under the bankruptcy
laws.





If
we do not receive additional capital when and in the amounts needed in the near
future, our ability to continue as a going concern is in substantial
doubt.





We previously established six equity
lines of credit with an unaffiliated third party (the “Equity Line Investor”)
upon which we drew to pay operating expenses.  We terminated the
Seventh Equity Line agreement January 2007, in light of regulatory changes, and
we do not anticipate that we will be able to enter into another similar
financing arrangement in the near future.  We have issued two
convertible debentures which are convertible into shares of our Class A common
stock, but we will need to receive additional capital in the near future to be
able to continue as a going concern.








10





Holders
of Fonix Class A common stock are subject to the risk of additional and
substantial dilution to their interests as a result of the issuances of Class A
common stock in connection with conversions of the outstanding
Debentures.





The following table describes the
number of shares of Class A common stock that would be issuable, assuming that
the full principal amount of the Southridge Debenture and the McCormack
Debenture were converted into shares of our Class A common stock as of March 31,
2008 (irrespective of the availability of registered shares), and further
assuming that the applicable conversion price at the time of such put were the
following amounts:





Hypothetical
      Conversion Price
            
            
            Shares
      issuable upon Conversion of Southridge Debenture
              (Principal
      amount of $850,000)
            
            
            Shares
      issuable upon Conversion of McCormack Debenture
              (Principal
      amount of $1,039,000)
            
            
            Total
      shares issuable upon conversion of outstanding Debentures$
            0.0001
            
            
            
            8,500,000,000
            
            
            
            10,390,000,000
            
            
            
            18,890,000,000$
            0.0002
            
            
            
            4,250,000,000
            
            
            
            5,195,000,000
            
            
            
            9,445,000,000$
            0.0003
            
            
            
            2,833,333,333
            
            
            
            3,463,333,333
            
            
            
            6,296,666,666$
            0.0005
            
            
            
            1,700,000,000
            
            
            
            2,078,000,000
            
            
            
            3,778,000,000$
            0.001
            
            
            
            850,000,000
            
            
            
            1,039,000,000
            
            
            
            1,889,000,000$
            0.002
            
            
            
            425,000,000
            
            
            
            519,500,000
            
            
            
            944,500,000$
            0.005
            
            
            
            170,000,000
            
            
            
            207,800,000
            
            
            
            377,800,000








Given the formulas for calculating the
shares to be issued in connection with conversions of the Southridge Debenture
and the McCormack Debenture, there effectively is no limitation on the number of
shares of Class A common stock which may be issued in connection with
conversions of the Southridge Debenture and the McCormack Debenture, except for
the number of shares available for issuance under the Company’s Certificate of
Incorporation.  As such, shareholders are subject to the risk of
substantial dilution to their interests as a result of our issuance of shares in
connection with conversions of the Southridge Debenture and the McCormack
Debenture.





Holders
of Fonix Class A common stock are subject to the risk of additional and
substantial dilution to their interests as a result of the issuances of Class A
common stock in connection with conversions of the outstanding series of
preferred stock.





The following table describes the
number of shares of Class A common stock that would be issuable, assuming that
the full principal amount of the various series of preferred stock listed were
converted into shares of our Class A common stock as of March 31, 2008
(irrespective of the availability of registered shares or conversion limitations
imposed by the applicable certificates of designation), and further assuming
that the applicable conversion price at the time of such put were the following
amounts:





Hypothetical
              Conversion
      Price
            
            
            Shares
      issuable upon Conversion of Series L Preferred Stock
              (1,519
      shares outstanding)
            
            
            Shares
      issuable upon Conversion of Series M Preferred Stock
              (150
      shares outstanding)
            
            
            Shares
      issuable upon Conversion of Series N Preferred Stock
              (1,350
      shares outstanding)
            
            
            Shares
      issuable upon Conversion of Fonix Speech Series B Preferred
      Stock*
              (125
      shares outstanding)
            
            
            Total
      shares issuable upon conversion of outstanding
              Preferred
      Stock$
            0.0001
            
            
            
            151,900,000,000
            
            
            
            15,000,000,000
            
            
            
            13,500,000,000
            
            
            
            12,500,000,000
            
            
            
            192,900,000,000$
            0.0002
            
            
            
            75,950,000,000
            
            
            
            7,500,000,000
            
            
            
            6,750,000,000
            
            
            
            6,250,000,000
            
            
            
            96,450,000,000$
            0.0003
            
            
            
            50,633,333,333
            
            
            
            5,000,000,000
            
            
            
            4,500,000,000
            
            
            
            4,166,666,666
            
            
            
            64,299,999,999$
            0.0005
            
            
            
            30,380,000,000
            
            
            
            3,000,000,000
            
            
            
            2,700,000,000
            
            
            
            2,500,000,000
            
            
            
            38,580,000,000$
            0.001
            
            
            
            15,190,000,000
            
            
            
            1,500,000,000
            
            
            
            1,350,000,000
            
            
            
            1,250,000,000
            
            
            
            19,290,000,000$
            0.002
            
            
            
            7,595,000,000
            
            
            
            750,000,000
            
            
            
            675,000,000
            
            
            
            625,000,000
            
            
            
            9,645,000,000$
            0.005
            
            
            
            3,038,000,000
            
            
            
            300,000,000
            
            
            
            270,000,000
            
            
            
            250,000,000
            
            
            
            3,858,000,000





*
            The
      Fonix Speech Series B Preferred Stock is convertible into shares of Fonix
      Corporation Class A common stock.







11


Given the formulas for calculating the
shares to be issued in connection with conversions of the various series of
preferred stock, there effectively is no limitation on the number of shares of
Class A common stock which may be issued in connection with conversions of the
outstanding shares of preferred stock, except for the number of shares available
for issuance under the Company’s Certificate of Incorporation.  As
such, shareholders are subject to the risk of substantial dilution to their
interests as a result of our issuance of shares in connection with conversions
of the series of preferred stock listed above.





Existing
shareholders likely will experience increased dilution with decreases in market
value of Class A common stock in connection with shares issued upon conversion
of the Southridge Debenture and the McCormack Debenture, which could have a
material adverse impact on the value of their shares.





The formula for determining the number
of shares of Class A common stock to be issued in connection with conversions of
the Southridge Debenture and the McCormack Debenture is based, in part, on the
market price of the Class A common stock and includes a discount from the market
price equal to 70% of the average of the two lowest closing bid prices of the
Class A common stock over a specified trading period.  As a result,
the lower the market price of our Class A common stock at and around the time
Southridge or McCormack convert the Southridge Debenture or the McCormack
Debenture, respectively, the more shares of Class A common stock Southridge and
McCormack would receive.  Any increase in the number of shares of
Class A common stock issued upon conversion of the Southridge Debenture and the
McCormack Debenture as a result of decreases in the prevailing market price
would compound the risks of dilution described in the preceding
paragraph.





There
is an increased potential for short sales of the Class A common stock due to the
sales of shares issued upon conversion of the Southridge Debenture, which could
materially affect the market price of the stock.





Downward pressure on the market price
of the Class A common stock that likely will result from sales of the Class A
common stock by Southridge issued in connection with a conversions of the
Southridge Debenture could encourage short sales of Class A common stock by
market participants other than Southridge.  Generally, short selling
means selling a security, contract or commodity not owned by the
seller.  The seller is committed to eventually purchase the financial
instrument previously sold.  Short sales are used to capitalize on an
expected decline in the security's price.  As Southridge converts
principal amount of the Southridge Debenture, we issue shares to Southridge,
which Southridge then sells into the market.  Additionally, as the
holders of the various serides of preferred stock convert their preferred shares
into Common Stock, those Common shares may be sold into the market as
well.  Such sales could have a tendency to depress the price of the
stock, which could increase the potential for short sales.





Under
applicable rules and regulations under the Exchange Act, any person engaged in
the distribution of the resale shares may not simultaneously engage in market
making activities with respect to the Common Stock for the applicable restricted
period, as defined in Regulation M, prior to the commencement of the
distribution.





Nevertheless,
significant amounts of such short selling by market participants other than
Southridge could place further downward pressure on the market price of our
Class A common stock, which would, in turn, result in additional shares being
issued in connection with conversions of the Debenture.





Certain
restrictions on the extent of conversions of the Southridge Debenture or our
various series of preferred stock may have little, if any, effect on the adverse
impact of our issuance of shares in connection with such convertible securities,
and as such, such selling shareholders may sell a large number of shares,
resulting in substantial dilution to the value of shares held by existing
shareholders.





Southridge has agreed, subject to
certain exceptions listed in the Southridge Debenture, to refrain from
converting amounts of the Debenture which would result in Southridge owning more
than 4.999% of the then-outstanding shares of Class A common
stock.  Similarly, the certificates of designation for the various
series of convertible preferred stock contain conversion limitations except in
certain circumstances that prohibit conversions equal to more than 4.999% of
outstanding common stock, except in certain circumstances.  These
restrictions, however, do not prevent these security holders from selling shares
of Class A common stock received in connection with a conversion, and then
receiving additional shares of Class A common stock in connection with a
subsequent conversion.  In this way, these security holders could sell
more than 4.999% of the outstanding Class A common stock in a relatively short
time frame while never holding more than 4.999% at one time.








12





We
have no dividend history and have no intention to pay dividends in the
foreseeable future.





We have never paid dividends on or in
connection with any class of our common stock and do not intend to pay any
dividends to common stockholders for the foreseeable future.





Competition
from other industry participants and rapid technological change could impede our
ability to achieve profitable operations.  Additionally, our current
and potential competitors, some of whom have greater resources and experience
than we do, may develop products and technologies that may cause a decline in
demand for, and the prices of, our Speech Products.





The speech-enabled technologies market
sector and telecommunications industry are characterized by rapid technological
change.  Competition in the speech-enabled technologies market is
based largely on marketing ability and resources, distribution channels,
technology and product superiority and product service and support.  A
number of companies have developed, or are expected to develop, products that
compete with our Speech Products and Core Technologies.  Competitors
in the speech technology software market include IBM, SpeechWorks International,
Nuance, and VoiceSignal.  We expect additional competition from other
companies, including Microsoft.  Furthermore, our competitors may
combine with each other, and other companies may enter our markets by acquiring
or entering into strategic relationships with our
competitors.  Current and potential competitors have established, or
may establish, cooperative relationships among themselves or with third parties
to increase the abilities of their speech and language technology products to
address the needs of our prospective customers.





Many of our current and potential
competitors have competitive advantages over us, including substantially greater
financial, technical, personnel and other resources, including brand name
recognition and long-standing relationships with customers.  These
resources may place us at competitive disadvantage in our existing speech and
telecommunications markets and may impair our ability to expand into new
markets, which could adversely affect our business.  If we fail to
grow rapidly or obtain additional capital we may not be able to compete with
larger, more well established companies.  There can be no assurance
that we will be able to successfully compete in our existing markets or in new
markets.





We
may incur a variety of costs to engage in future acquisitions of companies,
products or technologies to grow our customer base, to expand into new markets,
or to provide new services.  As such, the anticipated benefits of
those acquisitions may never be realized.





We may acquire other businesses to grow
our customer base, to expand into new markets, or to provide new
services.  We may make acquisitions of, or significant investments in,
complementary companies, products or technologies, although no additional
material acquisitions or investments are currently
pending.  Acquisitions may be accompanied by risks such
as:





•
            difficulties
      in assimilating the operations and employees of acquired
      companies;





•
            diversion
      of our management's attention from ongoing business
    concerns;





•
            our
      potential inability to maximize our financial and strategic position
      through the successful incorporation of acquired technology and rights
      into our products and services;





•
            additional
      expense associated with amortization of acquired
  assets;





•
            additional
      expense associated with understanding and development of acquired
      business;





•
            maintenance
      and implementation of uniform standards, controls, procedures and
      policies; and





•
            impairment
      of existing relationships with employees, suppliers and customers as a
      result of the integration of new management
  employees.








13





We
must attract and retain skilled personnel.  If we are unable to hire
and retain technical, sales and marketing and operational employees, our
business could be harmed.





Our ability to manage our growth will
be particularly dependent on our ability to develop and retain an effective
sales force and qualified technical and managerial personnel.  We
intend to hire additional employees, including software engineers, sales and
marketing employees and operational employees.  The competition for
qualified sales, technical, and managerial personnel in the communications
industry, as well as the speech technology industry, is intense, and we may not
be able to hire and retain sufficient qualified personnel.  In
addition, we may not be able to maintain the quality of our operations, control
our costs, maintain compliance with all applicable regulations, and expand our
internal management, technical, information and accounting systems in order to
support our desired growth, which could have an adverse impact on our
operations.





We
are subject to the risk that certain key personnel, including key scientific
employees named below, on whom we depend, in part, for our operations, will
cease to be involved with us.





We are dependent on the knowledge,
skill and expertise of several key scientific and business development
employees, including Dale Lynn Shepherd and R. Brian Moncur; and executive
officer,  Roger D. Dudley.  The loss of any of the key personnel
listed above could materially and adversely affect our future business
efforts.  Although we have taken reasonable steps to protect our
intellectual property rights including obtaining non-competition and
non-disclosure agreements from all of our employees and independent contractors,
if one or more of our key scientific employees, executive employees or
independent contractors resigns from Fonix to join a competitor, to the extent
not prohibited by such person's non-competition and non-disclosure agreement,
the loss of such personnel and the employment of such personnel by a competitor
could have a material adverse effect on us.  We do not presently have
any key man life insurance on any of our employees.





As
of the date of this Report, our board of directors consisted of one individual,
and we had only one executive officer.  As such, management of the
Company is consolidated in one individual.





On Wednesday, March 5, 2008, Thomas A.
Murdock resigned as Chairman of the Board, President, and Chief Executive
Officer of the Company.  Mr. Murdock also resigned all officer and
director positions he held with Fonix Speech, Inc., Fonix/AcuVoice, Inc.,
Fonix/Papyrus Corporation, Fonix UK, Ltd., and Fonix Sales, Korea Group, Ltd.,
all subsidiaries of the Company.  Additionally, on Wednesday, March 5,
2008, William A. Maasberg resigned as director of the Company, although he
continued to serve as our Chief Operating Officer until March 31,
2008.  In connection with the resignation of Messrs. Murdock and
Maasberg, the Company appointed Roger D. Dudley, who was serving as the
Company’s Executive Vice President and Chief Financial Officer, as the Company’s
Chairman, President, and Chief Executive Officer.  Mr. Dudley will
continue to serve as Chief Financial Officer.  Following the
resignations of Messrs. Murdock and Maasberg, Mr. Dudley is the sole director of
the Company.





Although our bylaws and Delaware
corporate law permit the continuation of business with a sole director, this
situation results in an absence of the typical checks and balances that are
present where a board of directors consists of even two
individuals.  Additionally, although we have in place controls and
procedures relating to the operation of the Company, the positions of Chief
Executive Officer (principal executive officer) and Chief Financial Officer
(principal accounting officer) are held by one individual, again resulting in
the absence of checks and balances.  Such consolidation of management
roles may also subvert certain of our operational controls and
procedures.








An
inability to market and develop additional services may adversely affect our
ability to retain existing customers or attract new customers.





Through Fonix Speech, we offer speech
technology solutions and products.  In order to address the future
needs of our customers, we will be required to market and develop additional
products and services.  We may not be able to continue to provide the
range of speech products or telecommunication services that our customers need
or desire.  We may lose some of our customers or be unable to attract
new customers if we cannot offer the products and services our customers need or
desire.








14





Our
common stock is considered a penny stock.  Penny stocks are subject to
special regulations, which may make them more difficult to trade on the open
market.





Securities in the OTC market are
generally more difficult to trade than those on the NASDAQ National Market, the
NASDAQ SmallCap Market or the major stock exchanges.  In addition,
accurate price quotations are also more difficult to obtain.  The
trading market for our common stock is subject to special regulations governing
the sale of penny stock.





A “penny stock” is defined by
regulations of the Securities and Exchange Commission as an equity security with
a market price of less than $5.00 per share.  The market price of our
Class A common stock has been less than $5.00 for several years.





If you buy or sell a penny stock, these
regulations require that you receive, prior to the transaction, a disclosure
explaining the penny stock market and associated risks.  Furthermore,
trading in our common stock would be subject to Rule 15g-9 of the Exchange Act,
which relates to non-NASDAQ and non-exchange listed securities.  Under
this rule, broker-dealers who recommend our securities to persons other than
established customers and accredited investors must make a special written
suitability determination for the purchaser and receive the purchaser's written
agreement to a transaction prior to sale.  Securities are exempt from
this rule if their market price is at least $5.00 per share.





Penny stock regulations will tend to
reduce market liquidity of our common stock, because they limit the
broker-dealers' ability to trade, and a purchaser's ability to sell the stock in
the secondary market.  The low price of our common stock will have a
negative effect on the amount and percentage of transaction costs paid by
individual shareholders.  The low price of our common stock may also
limit our ability to raise additional capital by issuing additional
shares.  There are several reasons for these
effects.  First, the internal policies of many institutional investors
prohibit the purchase of low-priced stocks.  Second, many brokerage
houses do not permit low-priced stocks to be used as collateral for margin
accounts or to be purchased on margin.  Third, some brokerage house
policies and practices tend to discourage individual brokers from dealing in
low-priced stocks.  Finally, broker's commissions on low-priced stocks
usually represent a higher percentage of the stock price than commissions on
higher priced stocks.  As a result, our shareholders will pay
transaction costs that are a higher percentage of their total share value than
if our share price were substantially higher.





We
have a limited Speech Product offering and many of our key technologies are
still in the product development stage.





Presently, there are a limited number
of commercially available Speech Products incorporating our Core
Technologies.  For Fonix to be ultimately successful, sales from these
Speech Products must be substantially greater.  An additional element
of our business strategy is to achieve revenues through strategic alliances,
co-development arrangements, and license arrangements with third
parties.  For example, we have entered into licensing and
joint-marketing agreements with Sony, Electronic Arts, Microsoft, Epson, Casio,
Canon, Ubisoft, OC3, Harmonix, and others.  These agreements provide
for joint marketing and application development for end-users or
customers.  To date, these agreements have not produced significant
revenues.  There can be no assurance that these collaboration
agreements will produce license or other agreements which will generate
significant revenues for us.





The
market for many of our Core Technologies and Speech Products is largely unproven
and may never develop sufficiently to allow us to capitalize on our Core
Technology and Speech Products.





The market for speech-enabled Speech
Products is rapidly evolving.  Additionally, our Speech Products are
new and, in many instances, represent a significant departure from technologies
which already have found a degree of acceptance in the speech-enabled
technologies marketplace.  Our financial performance will depend, in
part, on the future development, growth and ultimate size of the market for
speech-enabled applications and Speech Products generally, and applications and
products incorporating our Speech Products.  If the potential users of
speech-enabled software in general and our products in particular do not
perceive appropriate benefits, or if speech-enabled software platforms do not
achieve commercial acceptance, our business could be harmed or even
fail.








15





The Speech Products which incorporate
our Core Technologies will be competing with more conventional means of
information processing such as data entry, access by keyboard, mouse or
touch-tone telephone.  We believe that there is a substantial
potential market for applications and products incorporating advanced
speech-enabled technologies.  Nevertheless, such a market for our
Speech Products may never develop to the point that profitable operations can be
achieved or sustained.





Our
Speech Products may not achieve widespread acceptance by businesses or
telecommunications carriers, which could limit our ability to grow our
business.





Our ability to increase revenue in the
future depends on the acceptance of speech-enabling products and applications by
both our customers and end users.  The adoption and integration of
speech-enabling products and applications could be hindered by the perceived
costs of these new products and applications, as well as the reluctance of
enterprises that have invested substantial resources in existing applications to
replace their current systems with these new products and
applications.  Accordingly, in order to achieve commercial acceptance,
we will have to educate prospective customers, including large, established
companies, about the uses and benefits of speech-enabling products and
applications in general and our Speech Products in particular.  If
these efforts fail, or if speech-enabling products and technology platforms do
not achieve commercial acceptance, our business will not develop or may
subsequently fail.





Continued development of the market for
our Speech Products also will depend upon the following factors over which we
have little or no control:





•
            widespread
      deployment of speech-enabling applications by third parties, which is
      driven by consumer demand for services having a voice user
      interface;





•
            demand
      for new uses and applications of speech-enabling technology, including
      adoption of speech-enabled interfaces by companies that operate web
      sites;





•
            adoption
      of industry standards for speech-enabling and related technologies;
      and





•
            continuing
      improvements in hardware technology that may reduce the costs of
      speech-enabling technology
solutions.





In
many cases, the delivery of our Speech Products to end users is dependent upon
third-party integration and may be subject to delays and cancellations that are
beyond our control.





Generally, we are pursuing third-party
integration of our Speech Products into mass market, general business, personal
electronics products, and computing solutions.  Thus, lead time to
revenue recognition will be longer than software products directly released into
consumer channels.  Purchase of our Speech Products often requires a
significant expenditure by a customer.  Accordingly, the decision to
purchase our Speech Products typically requires significant pre-purchase
evaluation.  We spend significant time educating and providing
information to prospective customers regarding the use and benefits of our
Speech Products.  During this evaluation period, we may expend
substantial sales, marketing and management resources.





Further, our Speech Products sold and
integrated into customer applications and products are subject to both customer
production schedules and customer success in marketing their own products and
generating product sales.  Our revenues are thus subject to delays and
possible cancellation resulting from customer integration risks and
delays.





In cases where our contract with our
customers specifies milestones or acceptance criteria, we may not be able to
recognize license or services revenue until these conditions are
met.  We have in the past and may in the future experience unexpected
delays in recognizing revenue.  Consequently, the length of our sales
and implementation cycles and the varying order amounts for our Speech Products
make it difficult to predict the quarter in which revenue recognition may occur
and may cause license and services revenue and operating results to vary
significantly from period to period.  These factors could cause our
stock price to be volatile or to decline.








16





Our
Speech Products can have a long sales cycle and, as a result, our quarterly
operating results and our stock price may fluctuate.





The sales cycles for our Speech
Products are generally six to twelve months but may be shorter or longer
depending on the size and complexity of the order, the amount of services to be
provided and whether the sale is made directly by us or indirectly through an
OEM, VAR, or systems integrator.  The length of the sales cycles could
adversely impact our operating results.





Our
failure to respond to rapid change in the speech-enabled technologies market
could cause us to lose revenue and could harm our business.





Our success will depend substantially
upon our ability to enhance our existing Speech Products and to develop and
introduce, on a timely and cost-effective basis, new technologies, Speech
Products and features that meet changing end-user requirements and incorporate
technological advancements.  If we are unable to develop new Speech
Products and enhanced functionalities or technologies to adapt to these changes,
or if we cannot offset a decline in revenue from existing Speech Products with
sales of new Speech Products, our business will suffer.





Commercial acceptance of our Speech
Products will depend, among other things, on:





•
            the
      ability of our Speech Products to meet and adapt to the needs of our
      target markets;





•
            the
      performance and price of our Speech Products and our competitors'
      products; and





•
            our
      ability to deliver customer services directly and through our resellers,
      VARs and OEM partners.





In
order to increase our international sales, we must increase the foreign language
capacities of our Speech Products.  If we are unable to do so, we may
be unable to grow our revenue and execute our business strategy.





We intend to expand our international
sales, which requires a significant investment to create and refine different
language models for each particular language or dialect.  These
language models are required to create versions of products that allow end users
to speak the local language or dialect and be understood.  If we fail
to develop additional foreign language capacity of our Speech Products, our
ability to benefit from international market opportunities and to grow our
business will be limited.





Our
operations and financial condition could be adversely affected by our failure or
inability to protect our intellectual property or if our technologies are found
to infringe the intellectual property of a third party.





Dependence on proprietary
technology





Our success is heavily dependent upon
our proprietary technology.  Certain elements of our Core Technologies
are the subject of nine patents issued and allowed by the United States Patent
and Trademark Office and seven other patent applications which are
pending.  In addition to our patents, we rely on a combination of
copyright and trademark laws, trade secrets, confidentiality procedures and
contractual provisions to protect our proprietary rights.  Such means
of protecting our proprietary rights may not be adequate because such laws
provide only limited protection.  Despite precautions that we take, it
may be possible for unauthorized third parties to duplicate aspects of our
technologies or the current or future products or technologies of our business
units or to obtain and use information that we regard as
proprietary.  Additionally, our competitors may independently develop
similar or superior technology.  Policing unauthorized use of
proprietary rights is difficult, and some international laws do not protect
proprietary rights to the same extent as United States
laws.  Litigation periodically may be necessary to enforce our
intellectual property rights, to protect our trade secrets or to determine the
validity and scope of the proprietary rights of others.




















17





Risks of our infringement upon the
technology of unrelated parties or entities





We are not aware and do not believe
that any of our technologies or products infringe the proprietary rights of
third parties.  Nevertheless, third parties may claim infringement
with respect to our current or future technologies or products or products
manufactured by others and incorporating our technologies.  We expect
that developers of speech-enabled technologies increasingly will be subject to
infringement claims as the number of products and competitors in the industry
grows and the functionality of products in different industry segments
overlaps.  Responding to any such claims, whether or not they are
found to have merit, could be time consuming, result in costly litigation, cause
development delays, or require us to enter into royalty or license
agreements.  Royalty or license agreements may not be available on
acceptable terms or at all.  As a result, infringement claims could
have a material adverse affect on our business, operating results, and financial
condition.





There
may be additional unknown risks, which could have a negative effect on our
business.





The risks and uncertainties described
in this section are not the only ones facing us.  Additional risks and
uncertainties not presently known to us or that we currently deem immaterial may
also impair our business operations.  If any of the foregoing risks
actually occur, our business, financial condition, or results of operations
could be materially adversely affected.





ITEM
      2.
            PROPERTIES





We own no real property.  We
lease approximately 14,200 square feet of office space in Sandy, Utah, where
Fonix Speech conducts its principal scientific research, product development and
sales and marketing activities.  Our lease of that facility expires
August 31, 2010.  The average base monthly lease payment over the
five-year life of the lease is $26,000.





ITEM
      3.
            LEGAL
      PROCEEDINGS





Breckenridge Complaint – On
June 6, 2006, The Breckenridge Fund LLC (“Breckenridge”) filed a complaint
against the Company in the Supreme Court of the State of New York, County of
Nassau (the “Court”), in connection with a settlement agreement between the
Company and Breckenridge entered into in September 2005. In the Complaint,
Breckenridge alleged that the Company failed to pay certain amounts due under
the settlement agreement in the amount of $450,000. The Company denied the
allegations of Breckenridge’s complaint and filed a motion for summary
judgment.  Breckenridge also filed for summary judgment on its
complaint.





On
February 2, 2007, the Court granted Breckenridge’s motion for summary judgment,
denied the Company’s summary judgment motion, and directed that a hearing be
held to determine the amount owed by the Company to Breckenridge.  The
Company and Breckenridge entered into a stipulation that the Company owed
Breckenridge $1,530,000 plus interest at a rate of 9% from September 15, 2006 to
the date of entry of judgment.





The
Court’s judgment dated as of March 15, 2007, stated that the Company owed an
aggregate of $1,602,000 to Breckenridge.  The Company has accrued for
this settlement in the accompanying financial statements.  In February
2008, the Company entered into an amended settlement agreement with Breckenridge
under which the Company agreed to pay Breckenridge $540,000.  The
Company has paid Breckenridge $242,500 and is obligated to pay the balance of
$297,500 at the rate of $42,500 per month.





Hite Development Corporation v. Fonix
Corporation,Third District Court, Salt Lake County (Civil No.
070900883).  In January 2007, Hite Development Corporation (“Hite”)
brought a lawsuit against the Company claiming breach of contract and breach of
the covenant of good faith and fair dealing, alleging that the Company failed to
make certain payments under a settlement agreement with Hite dating from March
2005.  The complaint seeks approximately $33,000 plus
interest.  The Company filed its answer in May 2007.  The
case is currently in the discovery phase.  The Company intends to
defend against the claims in the complaint.





RR Donnelley Receivables Inc. v.
Fonix Corporartion,Third District Court, Salt Lake County (Civil No.
070412088).  In July 2007, RR Donnelley Receivables Inc. (“Donnelly”)
brought a lawsuit against the Company for alleged failure to pay for services
provided.  The complaint seeks approximately $21,000 plus
interest.  The Company filed its answer in August 2007, and filed a
motion to dismiss the action in December 2007.  That motion is
currently pending before the court.  If the Company’s motion to
dismiss is denied, the Company intends to defend against the claims in the
complaint.











18





ITEM
      4.
            SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY
HOLDERS





Annual
Meeting of Shareholders





On
January 17, 2008, Fonix Corporation held its Annual Meeting of Shareholders in
Salt Lake City, Utah.  The record date for the meeting was November
19, 2007, on which date there were 3,571,901,184 shares of our class A common
stock outstanding.





The first
matter voted upon at the meeting was the election of directors.  The
following directors were elected:





DIRECTOR
            
            SHARES
              VOTED
      IN FAVOR
            
            SHARES
              VOTED
      AGAINSTThomas
      A. Murdock
            
            1,694,934,207
            
            951,079,468Roger
      D. Dudley
            
            1,704,021,903
            
            941,991,772William
      A. Maasberg, Jr.
            
            1,705,404,363
            
            940,609,312





The
second matter voted upon at the meeting was the approval of the Board of
Directors’ selection of Hansen, Barnett & Maxwell as the Company’s
independent registered public accounting firm for the fiscal year ending
December 31, 2007.  The results of the voting were 2,141,121,105
shares in favor, 407,952,028 shares against and 96,940,542 shares
abstaining.





The third
matter voted upon at the meeting was the approval of an amendment to the
Company’s Certificate of Incorporation to increase our authorized capital from
5,000,000,000 shares of common stock to 20,000,000,000 shares of common
stock.  The results of the voting were 1,341,320,776 shares in favor,
1,260,005,456 shares against and 44,687,443 shares abstaining.





PART
II





ITEM
      5.
            MARKET
      FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
      PURCHASES OF EQUITY SECURITIES





Market information





Our Class A common stock is listed on
the OTC Bulletin Board under the trading symbol FNIX.  The following
table shows the range of high and low sales price information for our Class A
common stock as quoted on the OTC Bulletin Board for the calendar years 2006 and
2007 and for the first quarter of 2008.  The quotations reflect
inter-dealer prices, without retail mark-up, mark-down or commissions and may
not represent actual transactions.





Calendar
      Year2008
            
            
            2007
            
            
            2006High
            
            
            Low
            
            
            High
            
            
            Low
            
            
            High
            
            
            LowFirst
      Quarter
            
            $
            0.0004
            
            
            $
            0.0001
            
            
            $
            0.0028
            
            
            $
            0.0013
            
            
            $
            0.003
            
            
            $
            0.015Second
      Quarter
            
            
            
            
            
            
            
            
            
            $
            0.0025
            
            
            $
            0.0009
            
            
            $
            0.002
            
            
            $
            0.008Third
      Quarter
            
            
            
            
            
            
            
            
            
            $
            0.0013
            
            
            $
            0.0004
            
            
            $
            0.009
            
            
            $
            0.005Fourth
      Quarter
            
            
            
            
            
            
            
            
            
            $
            0.0016
            
            
            $
            0.0002
            
            
            $
            0.005
            
            
            $
            0.003








19





The high and low sales prices for our
Class A common stock on March 31, 2008, were $0.0003 and $0.0002,
respectively.  As of March 31, 2008, there were 5,752,687,745 shares
of Fonix Class A common stock outstanding, held by approximately 1,425 holders
of record and approximately 26,000 beneficial holders.  This number of
beneficial holders represents an estimate of the number of actual holders of our
stock, including beneficial owners of shares held in "nominee" or "street"
name.  The actual number of beneficial owners is not known to
us.





We have never declared any dividends on
our Class A common stock and it is expected that earnings, if any, in future
periods will be retained to further the development and sale of our Core
Technologies and products.  No dividends can be paid on our common
stock until such time as all accrued and unpaid dividends on our preferred stock
have been paid.





Recent
Sales of Unregistered Equity Securities





Equity Lines of
Credit–For the
year ended December 31, 2005, we issued 5,480,405 shares of Class A common stock
to the Equity Line Investor in full satisfaction of an outstanding put under the
Fifth Equity Line of $655,000.  The shares were issued without
registration under the 1933 Act in reliance on Section 4(2) of the 1933 Act and
the rules and regulations promulgated thereunder.  The resales of the
shares were subsequently registered under a registration statement on Form
S-2.





For the year ended December 31, 2005,
we received $4,263,000 in funds drawn under the Sixth Equity Line, less
commissions and fees of $141,000 and issued 75,000,000 shares of Class A common
stock to the Equity Line Investor.  The shares were issued without
registration under the 1933 Act in reliance on Section 4(2) of the 1933 Act and
the rules and regulations promulgated thereunder.  The resales of the
shares were subsequently registered under a registration statement on Form
S-1.





For the year ended December 31, 2005,
we received $3,127,000 in funds drawn under the Seventh Equity Line, less
commissions and fees of $106,000 and issued 100,000,000 shares of Class A common
stock to the Equity Line Investor.  The shares were issued without
registration under the 1933 Act in reliance on Section 4(2) of the 1933 Act and
the rules and regulations promulgated thereunder.  The resales of the
shares were subsequently registered under a registration statement on Form
S-1.





For the year ended December 31, 2006,
we received $3,378,000 in funds drawn under the Seventh Equity Line, less
commissions and fees of $114,000 and issued 300,000,000 shares of class A common
stock to the Equity Line Investor.  The shares were issued without
registration under the 1933 Act in reliance on Section 4(2) of the 1933 Act and
the rules and regulations promulgated thereunder.  The resales of the
shares were subsequently registered under a registration statement on Form
S-1.





Series I
PreferredStock -
On October 24, 2003, we entered into a private placement of shares of our Class
A common stock with The Breckenridge Fund, LLC, a New York limited liability
company (“Breckenridge”).  Under the terms of the private placement,
we agreed to sell 1,043,478 shares of our Class A common stock for $240,000 (the
“Private Placement Funds”).  The shares were issued without
registration under the 1933 Act in reliance on Section 4(2) of the Securities
Act of 1933, as amended (the “1933 Act”), and the rules and regulations
promulgated thereunder.





Subsequent to our receiving the Private
Placement Funds, but before any shares were issued in connection with the
private placement, we agreed with Breckenridge to rescind the private placement
of the shares and to restructure the transaction.  We retained the
Private Placement Funds as an advance in connection with the restructured
transaction.  We paid no interest or other charges to Breckenridge for
use of the Private Placement Funds.





Following negotiations with
Breckenridge, we agreed to sell to Breckenridge 3,250 shares of our Series I 8%
Convertible Preferred Stock (the “Preferred Stock”), for an aggregate purchase
price of $3,250,000, net of the Private Placement Funds which we had already
received.  The sale of the Preferred Stock to Breckenridge closed on
January 30, 2004.








20





In connection with the offering of the
Preferred Stock, we also issued to Breckenridge (i) warrants (the “Warrants”) to
purchase up to 965,839 additional shares of our Class A common stock; (ii)
1,931,677 shares of our Class A common stock (the “Additional Shares”); and
(iii) 482,919 shares of our Class A common stock (the “Fee
Shares”).  The shares of Series I Preferred Stock, the Warrants, the
Additional Shares, and the Fee Shares were issued without registration under the
1933 Act in reliance on Section 4(2) of the 1933 Act and the rules and
regulations promulgated thereunder.  We filed a registration statement
on Form S-2 to register the resales of the shares underlying the Warrants and
the Series I Preferred Stock, as well as the Additional Shares and the Fee
Shares on March 5, 2004.





For the year ended December 31, 2004,
we issued 8,435,869 shares of our Class A common stock upon conversion of 1,000
shares of our Series I Preferred Stock.





For the year ended December 31, 2005,
we issued 18,482,083 shares of our Class A common stock upon conversion of 1,078
shares of our Series I Preferred Stock.





As of
December 31, 2007, there were no shares of Series I Preferred Stock
outstanding.





Series J
Preferred Stock-Effective September 30, 2005, the Company entered into a 5% Series J
Convertible Preferred Stock Exchange Agreement (the "Exchange Agreement") with
Southridge Partners, LP ("Southridge"), a Delaware limited
partnership.  Pursuant to the Exchange Agreement, Southridge exchanged
all of the shares of 8% Series I Convertible Preferred Stock that it acquired
from Breckenridge for 1,452 shares of the Company's 5% Series J Convertible
Preferred Stock (the "Series J Preferred Stock").  The Series J
Preferred Stock has a stated value of $1,000 per share.





For the year ended December 31, 2005,
we issued 3,795,918 shares of our Class A common stock upon conversion of 93
shares of our Series J Preferred Stock.





For the year ended December 31, 2006,
we issued 15,028,249 shares of our Class A common stock upon conversion of 266
shares of our Series J Preferred Stock.





As of December 31, 2007, there were no
shares of Series J Preferred Stock outstanding.





Series K
Preferred Stock – Effective February 3, 2006, the Company’s Board of
Directors approved the designation and issuance of Series K 5% Convertible
Preferred Stock (the “Series K Preferred Stock”). The Series K Preferred Stock
entitled the holder to receive dividends in an amount equal to 5% of the stated
value of the then-outstanding balance of shares of Series K Preferred
Stock.  The dividends were payable in cash or shares of our Class A
common stock, at our option.





The
shares of Series K Preferred Stock were issued pursuant to a Series K 5%
Convertible Preferred Stock Exchange Agreement (the “Series K Agreement”), in
connection with which Southridge exchanged 1,093 shares of Series J Convertible
Preferred Stock for 1,093 shares of Series K Convertible Preferred
Stock.





The
Series K Preferred Stock was convertible into shares of our Class A common stock
at the option of the holder by using a conversion price of $0.01 per
share.





For the year ended December 31, 2006,
we issued 109,300,000 shares of Class A common stock upon conversion of 1,093
shares of our Series K Preferred Stock.





As of December 31, 2007, there were no
shares of Series K Preferred Stock outstanding.





Series L
Preferred
Stock                                           On
September 7, 2006, we entered into a Series L 9% Convertible Preferred Stock
Exchange Agreement (the "Exchange Agreement") with McCormack and Kenzie
Financial (“Kenzie”), a British Virgin Islands company.  Pursuant to
the Exchange Agreement, McCormack and Kenzie exchanged all of the shares of
Series H Preferred Stock that they acquired from sale of LTEL Holdings, for
1,960.8 and 39.2 shares, respectively, of our Series L 9% Convertible Preferred
Stock (the "Series L Preferred Stock").








21





For the year ended December 31, 2006,
we issued 489,870,090 shares of our Class A common stock upon conversion of 142
shares of our Series L Preferred Stock





For the year ended December 31, 2007,
we issued 2,777,153,204 shares of our Class A common stock upon conversion of
173 shares of our Series L Preferred Stock





Subsequent to December 31, 2007 and
through March 31, 2007, we issued 1,404,251,012 shares of our Class A common
stock upon conversion of 16 shares of our Series L Preferred Stock.





As of December 31, 2007, there were
1,535 shares of Series L Preferred Stock outstanding.





Series M
Preferred Stock – On April 4, 2007, the Company entered into a Series M
9% Convertible Preferred Stock Exchange Agreement (the “Exchange Agreement”)
with Sovereign Partners, LP (“Sovereign”). Pursuant to the Exchange Agreement,
Sovereign exchanged 150 shares of the Company’s Series L Preferred Stock for 150
shares of the Company’s Series M 9% Convertible Preferred Stock (the “Series M
Preferred Stock”).





The
Series M Preferred Stock entitles Sovereign or its assignees to receive
dividends in an amount equal to 9% of the then-outstanding balance of shares of
Series M Preferred Stock. The dividends are payable in cash or shares of the
Company’s Class A common stock, at the Company’s option.





The
Series M Preferred Stock may be converted into common stock of the Company at
the option of the holder by using a conversion price which is the lower of (A)
80% of the average of the two (2) lowest closing bid prices for the twenty-day
trading period prior to the conversion date, or (B) $0.004.





Because
the shares of Series M were issued in exchange for the outstanding shares of
Series L Preferred Stock, we did not receive any proceeds in connection with the
issuance of the Series M Preferred Stock.





Under the
Exchange Agreement and the Series M Terms, Sovereign or its assignees may
convert shares of Series M Preferred Stock into shares of our common stock. The
Company’s issuances of shares of common stock upon any conversion of the Series
M Preferred Stock will be made without registration under the securities Act of
1933 (the “1933 Act”) in reliance on Section 4(2) of the 1933 Act and the rules
and regulations promulgated thereunder.





During
the year ended December 31, 2007, and through March 31, 2008 there were no
conversions of Series M Preferred Stock.





As of
December 31, 2007, there were 150 shares of Series M Preferred Stock
outstanding.





Series N
Preferred Stock – On August 24, 2007, the Company entered into a
Securities Purchase Agreement (the “Purchase Agreement”) by and among the
Company, Trillium Partners, LP (“Trillium”), and other unnamed future investors
relating to the purchase and sale of the Company’s Series N 9% Convertible
Preferred Stock (the “Series N Preferred Stock”) in the amount of
$2,400,000.





Pursuant
to the Purchase Agreement, the Company agreed to sell up to 2,400 shares of the
Preferred Stock at a per share price of $1,000, to the various
investors.  The gross proceeds to the Company, if all shares of the
Series N Preferred Stock are sold, will be $2,400,000.  Trillium
purchased 1,350shares between August 24, 2007 and December 31, 2007 of Preferred
Stock pursuant to the Purchase Agreement, yielding gross proceeds to the Company
of $1,350,000.  The Company anticipates that there will be additional
sales to various investors of the Preferred Stock pursuant to the Purchase
Agreement.





The
shares of Preferred Stock are convertible into shares of the Company’s Class A
common stock.  The shares may be converted into common stock of the
Company at the option of the holder by using a conversion price which shall be
eighty percent (80%) of the two (2) lowest closing bid prices over the twenty
trading days prior to the conversion date.








22





The sale
of the Preferred Stock was made without registration under the Securities Act of
1933 (the “1933 Act”) in reliance on Section 4(2) of the 1933 Act and the rules
and regulations promulgated thereunder.  The Company’s issuances of
shares of common stock upon any conversion of the Preferred Stock will be made
without registration under the 1933 Act in reliance on Section 4(2) of the 1933
Act and the rules and regulations promulgated thereunder.





During the year ended December 31,
2007, there were no conversions of Series N Preferred
Stock.  Subsequent to December 31, 2007, and through March 31, 2008,
there were no conversions of our Series N Preferred Stock.





As of December 31, 2007, there were
1,350 shares of Series N Preferred Stock outstanding.





Fonix Speech,
Inc., Series B Convertible Preferred Stock – On April 4, 2007, the
Company entered into a Securities Purchase Agreement (the “FSI Agreement”) by
and among the Company, Fonix Speech, Inc. (“FSI”), and Sovereign. FSI is a
wholly owned subsidiary of the Company.





Pursuant
to the FSI Agreement, FSI sold 125 shares of its Series B 9% Convertible
Preferred Stock (the “FSI Preferred Stock”), at a per share price of $10,000, to
Sovereign. The gross proceeds to FSI were $1,250,000.





The
shares of FSI Preferred Stock are convertible into shares of the Company’s Class
A common stock. The FSI Preferred Stock may be converted into common stock of
the Company at the option of the holder by using a conversion price which is the
lower of (A) 80% of the average of the two (2) lowest closing bid prices for the
twenty-day trading period prior to the conversion date, or (B)
$0.004.





The
Company’s issuances of shares of common stock upon any conversion of the FSI
Series B Preferred Stock will be made without registration under the securities
Act of 1933 (the “1933 Act”) in reliance on Section 4(2) of the 1933 Act and the
rules and regulations promulgated thereunder.





During
the year ended December 31, 2007, there were no conversions of FSI Series B
Preferred Stock.  Subsequent to December 31, 2007, and through
March  31, 2008, there were no conversions of FSI Series B Preferred
Stock.





As of December 31, 2007, there were 125
shares of FSI Series B Preferred Stock outstanding.





LecStar
Acquisition-On
February 24, 2004, we acquired all of the capital stock of LTEL Holdings
Corporation (“LTEL”) and its wholly-owned subsidiaries, LecStar Telecom, Inc.,
and LecStar DataNet, Inc. (collectively “LecStar”).  The results of
LecStar's operations are included in the consolidated financial statements from
February 24, 2004 as discontinued operations.  We acquired LecStar to
provide us with a recurring revenue stream, a growing customer base, new
marketing channels for our Core Technologies and Speech Products, and to reduce
the cost of capital.





In accordance with SFAS No. 141,
“Business Combinations,” the aggregate purchase price was $12,800,000 and
consisted of the issuance of 7,036,802 shares of Class A common stock valued at
$4,176,000 or $0.59 per share, 2,000 shares of 5% Series H nonvoting,
nonconvertible preferred stock (the “Series H Preferred Stock”) with a stated
value of $10,000 per share valued at $4,000,000, and a 5% $10,000,000 secured,
six-year promissory note (the “Note”) valued at $4,624,000.  The
number of shares of Class A common stock issued under the terms of the purchase
agreement was determined by dividing $3,000,000 by 90 percent of the average
closing bid price of our common stock for the first 30 of the 33 consecutive
trading days immediately preceding the date certain regulatory approvals were
deemed effective.  Under the terms of the acquisition agreement, the
number of Class A common shares was determinable on February 19,
2004.  Accordingly, the value of the shares of Class A common stock
was established, in accordance with SFAS No. 141, as the average market price of
the Fonix common stock over the three-day period through February 19,
2004.  The values of the Series H Preferred Stock and the Note were
determined based on the estimated risk-adjusted cost of capital to Fonix at the
date of the acquisition.  The fair value of the Series H Preferred
Stock was based on an imputed yield rate of 25 percent per annum, and the
discount on the Note of $5,376,000 was based on an imputed interest rate of 25
percent per annum.








23





The purchase price was allocated to the
assets acquired and liabilities assumed based on their estimated fair
values.  Negative goodwill was not recognized in connection with the
acquisition of LecStar.  Instead, the excess of the fair value of the
net assets over the purchase price was allocated as a pro rata reduction of the
amounts that otherwise would have been assigned to the long-term
assets.  At February 24, 2004, the purchase price was allocated to the
assets acquired and the liabilities assumed as follows:





Current
      Assets
            
            $
            2,390,000Investments
            
            
            237,000Property
      and equipment
            
            
            148,000Deposits
      and other assets
            
            
            984,000Intangible
      assets
            
            
            18,500,000Total
      assets acquired
            
            
            22,259,000Current
      liabilities
            
            
            (8,923,000
            )Long-term
      portion of notes payable
            
            
            (536,000
            )Total
      liabilities assumed
            
            
            (9,459,000
            )Net
      Assets Acquired
            
            $
            12,800,000





Of the $18,500,000 of acquired
intangible assets, $1,110,000 was assigned to LecStar's brand name, which had an
indefinite life and therefore was not subject to amortization; $14,430,000 was
assigned to the local telephone exchange customer base, with a 2.9-year
weighted-average useful life; and $2,960,000 was assigned to established
marketing contracts and agreements with utility companies, with a 1.8-year
estimated useful life.  Total intangible assets subject to
amortization had a weighted-average useful life of approximately 2.7
years.





Dividends on the stated value of the
outstanding Series H Preferred Stock were payable at the rate of 5% per annum as
and when declared by the Board of Directors.  Dividends on the Series
H Preferred Stock and interest on the Note are payable in cash or, at our
option, in shares of Class A common stock.  We previously registered
the Class A common stock issued in the acquisition and 12,000,000 additional
shares of Class A common stock issuable as payment of interest on the Note and
as dividends on the Series H Preferred Stock.  The Note was secured by
the assets and capital stock of our subsidiary and the capital stock of LTEL and
LecStar.





For the year ended December 31, 2005,
we issued 29,417,578 shares of our Class A common stock as payment of principal
and interest on long-term debt of $1,251,000 and 27,275,299 shares of our Class
A common stock as payment of $1,126,000 of dividends on Series H Preferred
Stock.





For the year ended December 31, 2006,
we issued 2,838,412 shares of our Class A common stock as payment of $65,000 of
dividends on Series H Preferred Stock.





There have been no repurchases of
equity securities by Fonix during the years ended December 31, 2007, 2006 or
2005.





ITEM
      6.
            SELECTED
      FINANCIAL DATA





The selected consolidated financial
information set forth below is derived from our consolidated balance sheets and
statements of operations as of and for the years ended December 31, 2007, 2006,
2005, 2004 and 2003.  The data set forth below should be read in
conjunction with “Management’s Discussion and Analysis of Financial Condition
and Results of Operations” and the consolidated financial statements and related
notes thereto included in this Report.








24








For
      the Year Ended December 31,2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Statement
      of Operations Data:Revenues
            
            $
            1,838,000
            
            
            $
            1,329,000
            
            
            $
            1,358,000
            
            
            $
            1,229,000
            
            
            $
            2,384,000Cost
      of Revenues
            
            
            141,000
            
            
            
            18,000
            
            
            
            70,000
            
            
            
            33,000
            
            
            
            1,029,000Selling,
      general and administrative expenses
            
            
            2,479,000
            
            
            
            5,356,000
            
            
            
            4,762,000
            
            
            
            4,706,000
            
            
            
            7,004,000Legal
      settlement expense
            
            
            –
            
            
            
            –
            
            
            
            2,080,000
            
            
            
            –
            
            
            
            –Product
      development and research
            
            
            1,572,000
            
            
            
            2,143,000
            
            
            
            2,196,000
            
            
            
            2,559,000
            
            
            
            5,141,000Impairment
      loss on goodwill
            
            
            2,631,000
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            302,000Other
      expense, net
            
            
            19,944,000
            
            
            
            (4,508,000
            )
            
            
            (1,044,00
            )
            
            
            (543,000
            )
            
            
            (2,451,000
            )Gain
      (loss) from continuing operations, before equity in net loss of
      affiliate
            
            
            14,959,000
            
            
            
            (10,696,000
            )
            
            
            (8,794,000
            )
            
            
            (6,612,000
            )
            
            
            (13,183,000
            )Equity
      in loss of affiliate
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            (360,000
            )Net
      gain (loss) from continuing operations
            
            
            14,959,000
            
            
            
            (10,696,000
            )
            
            
            (8,794,000
            )
            
            
            (6,612,000
            )
            
            
            (13,543,000
            )Net
      loss from discontinued operations
            
            
            –
            
            
            
            (11,247,000
            )
            
            
            (13,837,000
            )
            
            
            (8,536,000
            )
            
            
            –Net
      gain (loss)
            
            
            14,959,000
            
            
            
            (21,943,000
            )
            
            
            (22,631,000
            )
            
            
            (15,148,000
            )
            
            
            (13,543,000
            )Preferred
      stock dividends
            
            
            (1,702,000
            )
            
            
            (18,735,000
            )
            
            
            (1,265,000
            )
            
            
            (3,927,000
            )
            
            
            –Net
      gain (loss) attributable to common stockholders
            
            
            13,257,000
            
            
            
            (40,678,000
            )
            
            
            (23,896,000
            )
            
            
            (19,075,000
            )
            
            
            (13,543,000
            )Basic
      net income (loss) per common sharefrom
      continuing operations
            
            $
            0.01
            
            
            $
            (0.04
            )
            
            $
            (0.04
            )
            
            $
            (0.12
            )
            
            $
            (0.50
            )Basic
      and diluted net loss per common sharefrom
      discontinued operations
            
            
            –
            
            
            $
            (0.01
            )
            
            $
            (0.05
            )
            
            $
            (0.10
            )
            
            
            –Basic
      weighted average number of common shares outstanding
            
            
            2,417,708,937
            
            
            
            768,076,936
            
            
            
            261,894,849
            
            
            
            89,795,728
            
            
            
            26,894,005Diluted
      net income per common sharefrom
      continuing operations
            
            $
            0.00
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –Diluted
      weighted average number of common shares outstanding
            
            
            100,629,394,604
            
            
            
            768,076,936
            
            
            
            261,894,849
            
            
            
            89,795,728
            
            
            
            26,894,005








As
      of December 31,2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Balance
      Sheet Data:Current
      assets
            
            $
            87,000
            
            
            $
            9,000
            
            
            $
            1,465,000
            
            
            $
            2,120,000
            
            
            $
            342,000Total
      assets
            
            
            211,000
            
            
            
            2,805,000
            
            
            
            9,293,000
            
            
            
            19,000,000
            
            
            
            3,173,000Current
      liabilities
            
            
            34,471,000
            
            
            
            52,966,000
            
            
            
            20,469,000
            
            
            
            15,700,000
            
            
            
            13,530,000Long-term
      debt, net of current portion
            
            
            3,556,000
            
            
            
            2,988,000
            
            
            
            4,050,000
            
            
            
            5,358,000
            
            
            
            40,000Stockholders’
      (deficit)
            
            
            (37,816,000
            )
            
            
            (53,149,000
            )
            
            
            (15,226,000
            )
            
            
            (2,058,000
            )
            
            
            (10,397,000
            )








25




ITEM
      7.
              MANAGEMENT'S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS


THIS
REPORT ON FORM 10-K CONTAINS, IN ADDITION TO HISTORICAL INFORMATION,
FORWARD-LOOKING STATEMENTS THAT INVOLVE SUBSTANTIAL RISKS AND
UNCERTAINTIES.  ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE
RESULTS ANTICIPATED BY FONIX AND DISCUSSED IN THE FORWARD-LOOKING
STATEMENTS.  WHEN USED IN THIS ANNUAL REPORT, WORDS SUCH AS
"BELIEVES," "EXPECTS," "INTENDS," "PLANS," "ANTICIPATES," "ESTIMATES," AND
SIMILAR EXPRESSIONS ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS,
ALTHOUGH THERE MAY BE CERTAIN FORWARD-LOOKING STATEMENTS NOT ACCOMPANIED BY SUCH
EXPRESSIONS.  ADDITIONALLY, STATEMENTS THAT RELATE TO THE FUTURE
BUSINESS DEVELOPMENT, FINANCIAL PROJECTIONS, CAPITAL RAISING, CAPITAL
REQUIRMENTS, GROWTH OF MARKETES OR CUSTOMER BASES, OR FUTURE BUSINESS
COMBINATIONS MAY ALSO INCLUDE FORWARD-LOOKING STATEMENTS.FACTORS THAT COULD
CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES ARE DISCUSSED BELOW IN THE SECTION
ENTITLED "INFORMATION CONCERNING FORWARD-LOOKING STATEMENTS" AND UNDER THE
HEADING "CERTAIN SIGNIFICANT RISK FACTORS," ABOVE.  FONIX CORPORATION
SPECIFICALLY DISCLAIMS ANY OBLIGATION OR INTENTION TO UPDATE ANY FORWARD LOOKING
STATEMENT.





The following Management’s discussion
and Analysis of financial Condition and Results of Operations (“MD&A”) is
intended to help the reader understand Fonix Corporation, our operations and our
present business environment.  MD&A is provided as a supplement
to, and should be read in conjunction with, our consolidated financial
statements and the accompanying notes thereto contained in Item 8 of this
report.  This overview summarizes MD&A, which includes the
following sections:





·
            Overview – a general
      description of our business and the markets in which we operate; our
      objective; our areas of focus; and challenges and risks of our
      business.





·
            Significant Accounting
      Policies– a discussion of accounting policies that require
      critical judgments and estimates.





·
            Results of Operations–
      an analysis of our Company’s consolidated results of operations for the
      three years presented in our consolidated financial
      statements.  Except to the extent that differences among our
      operating segments are material to an understanding of our business as a
      whole, we present the discussion in the MD&A on a consolidated
      basis.





·
            Liquidity and Capital
      Resources– an analysis of cash flows; off-balance sheet
      arrangements and aggregate contractual obligations; the impact of
      foregoing exchange; an overview of financial position; and the impact of
      inflation and changing prices.





We intend
for this discussion to provide the reader with information that will assist in
understanding our financial statements, the changes in certain key items in
those financial statements from year to year, and the primary factors that
accounted for those changes, as well as how certain accounting principles affect
our financial statements.  The discussion also provides information
about the financial results of the various segments of our business to provide a
better understanding of how those segments and their results affect the
financial condition and results of operations of the Company as a
whole.  This discussion should be read in conjunction with our
financial statements as of December 31, 2007, and the year then ended and the
notes accompanying those financial statements.





Overview





We are engaged in providing value-added
speech technologies through Fonix Speech, Inc. (“Fonix Speech”).  We
offer speech-enabling technologies including automated speech recognition
(“ASR”) and text-to-speech (“TTS”) through Fonix Speech.  We offer our
speech-enabling technologies to markets for wireless and mobile devices,
computer telephony, server solutions and personal software for consumer
applications.  We have received various patents for certain elements
of our core technologies and have filed applications for other patents covering
various aspects of our technologies.  We seek to develop relationships
and strategic alliances with third-party developers and vendors in
telecommunications, computers, electronic devices and related industries,
including producers of application software, operating systems, computers and
microprocessor chips.  Revenues are generated through licensing of
speech-enabling technologies, maintenance contracts and services.








26





We previously operated a
telecommunications business, the results of which were included in prior SEC
filings.  On October 2, 2006, LecStar Telecom Inc., a Georgia
corporation (“LecStar Telecom”), LecStar DataNet, Inc., a Georgia corporation
(“LecStar DataNet”), LTEL Holdings Corporation (“LTEL Holdings”), a Delaware
corporation, and Fonix Telecom Inc., a Delaware corporation (“Fonix Telecom”),
each of which are direct or indirect subsidiaries of Fonix, filed for bankruptcy
protection in the United States Bankruptcy Court for the District of Delaware
(the “Bankruptcy Court”).  The case numbers are as
follows:  LTEL Holdings Corporation, 06-11081 (BLS); LecStar Telecom,
Inc., 06-11082 (BLS); LecStar DataNet, Inc., 06-11083 (BLS); Fonix Telecom,
Inc., 06-11084 (BLS).)





LecStar
Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom sought protection
under Chapter 7 of title 11 of the U.S. Bankruptcy Code, 11 U.S.C ss 101 et seq.
(the “Bankruptcy Code”).  Pursuant to Bankruptcy Code Section 701, on
October 3, 2006, Alfred Thomas Guliano was appointed the interim trustee for
LecStar Telecom, LecStar DataNet, LTEL Holdings, and Fonix
Telecom.  As these subsidiary companies were in Chapter 7 Bankruptcy
proceedings, as of the date of this Report, the results of their operations have
been included as discontinued operations.





For the years ended December 31, 2007,
2006 and 2005, we generated revenues of  $1,838,000, $1,329,000 and
$1,358,000, respectively; with income of $14,959,000 in 2007 and  net
losses of $21,943,000 and $22,631,000, for 2006 and 2005 respectively, and had
negative cash flows from operating activities of $2,312,000, $4,048,000 and
$8,643,000, respectively.  As of December 31, 2007,  we had
an accumulated deficit of $277,943,000, negative working capital of $34,384,000,
derivative liabilities of $20,742,000 related to the issuance of Series L
Preferred Stock,  Series M Preferred Stock, Series N Preferred
Stock,  Series E Convertible Debentures and Series B Preferred Stock
of our subsidiary, accrued liabilities and accrued settlement obligation of
$5,045,000, accounts payable of $1,532,000 and current portion of notes payable
of $3,833,000, Series E debentures of $1,754,000 and deferred revenues of
$445,000.We expect to continue to incur significant losses and negative cash
flows from operating activities at least through December 31, 2008, primarily
due to expenditure requirements associated with continued marketing and
development of our speech-enabling technologies.





We are continually developing new
product offerings in the ASR businesses in an effort to increase our revenue
stream, and we are continuing to work with our existing customers to increase
sales.  We have also experienced operating expense decreases through
headcount reductions and overall cost reduction measures.  Through the
combination of increased recurring revenues and the overall operating cost
reduction strategies we have implemented, we hope to achieve positive cash flow
from operations in the next 18-24 months.  However, there can be no
assurance that we will be able to achieve positive cash flow from operations
within this time frame.





Historically, our cash resources,
limited to collections from customers, draws on equity lines of credit and
loans, have not been sufficient to cover operating expenses.  We
periodically engage in discussions with various sources of financing to
facilitate our cash requirements including buyers of both debt and equity
securities.  To date, no additional sources of funding offering terms
superior to those available under equity lines have been implemented, and we
rely on first, cash generated from operations, and second, cash provided through
convertible debt financing arrangements.  We will need to generate
approximately $2 to $3 million to continue operations for the next twelve
months.  There can be no assurance that we will be able to obtain such
financing or that, if we can obtain such financing, it will be on terms
favorable to us.





As
discussed above, on Wednesday, March 5, 2008, Thomas A. Murdock resigned as
Chairman of the Board, President, and Chief Executive Officer of the
Company.  Additionally, Mr. Murdock resigned all officer and director
positions he held with Fonix Speech, Inc., Fonix/AcuVoice, Inc., Fonix/Papyrus
Corporation, Fonix UK, Ltd., and Fonix Sales, Korea Group, Ltd., all
subsidiaries of the Company.  Additionally, on Wednesday, March 5,
2008, William A. Maasberg resigned as director of the Company, and on Monday,
March 31, 2008, Mr. Maasberg resigned as our Chief Operating
Officer.





In connection with the resignation of
Messrs. Murdock and Maasberg, the Company appointed Roger D. Dudley, who was
serving as the Company’s Executive Vice President and Chief Financial Officer,
as the Company’s Chairman, President, and Chief Executive
Officer.  Mr. Dudley will continue to serve as Chief Financial
Officer.  Following the resignations of Messrs. Murdock and Maasberg,
Mr. Dudley is the sole director and executive officer of the
Company.








27





Significant
Accounting Policies





The discussion and
analysis of our financial condition and results of operations are based upon our
consolidated financial statements, which have been prepared in accordance with
accounting principles generally accepted in the United States.  The
preparation of these financial statements requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of sales and expenses during the reporting
period.  Significant accounting policies and areas where substantial
judgments are made by management include:





Accounting
estimates-The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
the disclosures of contingent assets and liabilities at the date of the
financial statements, and the reported amounts of revenues and expenses during
the reporting period.  Actual results could differ from those
estimates.





Valuation of
long-lived assets - The carrying values of our long-lived assets are
reviewed for impairment whenever events or changes in circumstances indicate
that they may not be recoverable.  When such an event occurs, we
project undiscounted cash flows to be generated from the use of the asset and
its eventual disposition over the remaining life of the asset.  If
projections indicate that the carrying value of the long-lived asset will not be
recovered, the carrying value of the long-lived asset, other than software
technology, is reduced by the estimated excess of the carrying value over the
projected discounted cash flows.





Goodwill
–
Goodwill represents the excess of the cost over the fair value of net assets of
acquired businesses. Goodwill is not amortized, but is tested for impairment
quarterly or when a triggering event occurs.  The testing for
impairment requires the determination of the fair value of the asset or entity
to which the goodwill relates (the reporting unit).  The fair value of
a reporting  unit is determined based upon a weighting of the quoted
market price of our common stock and present value techniques based upon
estimated future cash flows of the reporting unit, considering future revenues,
operating costs, the risk-adjusted discount rate and other
factors.  Impairment is indicated if the fair value of the reporting
unit is allocated to the assets and liabilities of that unit, with the excess of
the fair value of the reporting unit over the amounts assigned to its assets and
liabilities assigned to the fair value of goodwill.  The amount of
impairment of goodwill is measured by the excess of the goodwill’s carrying
value over its fair value.  At December 31, 2007, we tested the
carrying value of goodwill and determined that it was fully
impaired.





Revenue
recognition – We recognize revenue when pervasive evidence of an
arrangement exists, services have been rendered or products have been delivered,
the price to the buyer is fixed and determinable and collectibility is
reasonable assured.  Revenues are recognized by us based on the
various types of transactions generating the revenue.  For software
sales, we recognize revenues in accordance with the provisions of Statement of
Position No. 97-2, “Software Revenue Recognition” and related
interpretations.We generate
revenues from licensing the rights to its software products to end users and
from royalties.  For telecommunications services, revenue is
recognized in the period that the service is provided.





For Fonix
Speech, revenue of all types is recognized when acceptance of functionality,
rights of return, and price protection are confirmed or can be reasonably
estimated, as appropriate.  Revenues from development and consulting
services are recognized on a completed-contract basis when the services are
completed and accepted by the customer.  The completed-contract method
is used because our contracts are typically either short-term in duration or we
are unable to make reasonably dependable estimates of the costs of the
contracts.  Revenue for hardware units delivered is recognized when
delivery is verified and collection assured.





Revenue
for products distributed through wholesale and retail channels and through
resellers is recognized upon verification of final sell-through to end users,
after consideration of rights of return and price
protection.  Typically, the right of return on such products has
expired when the end user purchases the product from the retail
outlet.  Once the end user opens the package, it is not returnable
unless the medium is defective.





When
arrangements to license software products do not require significant production,
modification or customization of software, revenue from licenses and royalties
are recognized when persuasive evidence of a licensing arrangement exists,
delivery of the software has occurred, the fee is fixed or determinable, and
collectibility is probable.  Post-contract obligations, if any,
generally consist of one year of support including such services as customer
calls, bug fixes, and upgrades.  Related revenue is recognized over
the period covered by the agreement.  Revenues from maintenance and
support contracts are also recognized over the term of the related
contracts.








28





Revenues
applicable to multiple-element fee arrangements are bifurcated among the
elements such as license agreements and support and upgrade obligations using
vendor-specific objective evidence of fair value.  Such evidence
consists primarily of pricing of multiple elements as if sold as separate
products or arrangements.  These elements vary based upon factors such
as the type of license, volume of units licensed, and other related
factors.





Deferred
revenue as of December 31, 2007, consisted of the following:




Description
            Criteria
      for Recognition
            December
      31, 2007Deferred
      unit royalties and license fees
            Delivery
      of units to end users or expiration of contract
            $  445,000





Cost of
revenues-  Cost of revenues from license, royalties, and maintenance
consists of costs to distribute the product, installation and support personnel
compensation, amortization and impairment of capitalized speech software costs,
licensed technology, and other related costs.  Cost of service
revenues consists of personnel compensation and other related
costs.





Software
Technology Development and Production Costs- All costs incurred to
establish the technological feasibility of speech software technology to be
sold, leased, or otherwise marketed are charged to product development and
research expense.  Technological feasibility is established when a
product design and a working model of the software product have been completed
and confirmed by testing.  Costs to produce or purchase software
technology incurred subsequent to establishing technological feasibility are
capitalized.  Capitalization of software costs ceases when the product
is available for general release to customers.  Costs to perform
consulting or development services are charged to cost of revenues in the period
in which the corresponding revenues are recognized.  Costs of
maintenance and customer support are charged to expense when related revenue is
recognized or when these costs are incurred, whichever occurs
first.





Capitalized software technology costs
were amortized on a product-by-product basis.  Amortization was
recognized from the date the product was available for general release to
customers as the greater of (a) the ratio that current gross revenue for a
product bears to total current and anticipated future gross revenues for that
product or (b) the straight-line method over the remaining estimated economic
life of the products.  Amortization was charged to cost of
revenues.





We assessed unamortized capitalized
software costs for possible write down on a quarterly basis based on net
realizable value of each related product.  Net realizable value was
determined based on the estimated future gross revenues from a product reduced
by the estimated future cost of completing and disposing of the product,
including the cost of performing maintenance and customer
support.  The amount by which the unamortized capitalized costs of a
software product exceeded the net realizable value of that asset was written
off.





Stock-Based
Employee Compensation -Effective January 1, 2006, we adopted Statement of Financial Accounting
Standards No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), an amendment of
SFAS No. 123, “Accounting for Stock-Based Compensation,” using the modified
prospective transition method.  Under this transition method,
compensation costs are recognized beginning with the effective date: (a) based
on the requirements of SFAS 123(R) for all share-based awards granted after the
effective date and (b) based on the requirements of SFAS 123 for all awards
granted to employees prior to the effective date of SFAS 123(R) that remain
unvested on the effective date.  Accordingly, we did not restate the
results of prior periods.  The most notable change resulting from the
adoption of SFAS 123(R) is that compensation expense associated with stock
options is now recognized in our Statements of Operations, rather than being
disclosed in a pro forma footnote to our financial statements.








29





Prior to January 1, 2006, we accounted
for stock options granted under our Stock Option Plans under the recognition and
measurement provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations, as permitted by Statement of
Financial Accounting Standards No. 123, Accounting for Stock-Based
Compensation.





Imputed Interest
Expense and Income - Interest is imputed on long-term debt obligations
and notes receivable where management has determined that the contractual
interest rates are below the market rate for instruments with similar risk
characteristics.





Foreign Currency
Translation-The
functional currency of our Korean subsidiary is the South Korean
won.  Consequently, assets and liabilities of the Korean operations
are translated into United States dollars using current exchange rates at the
end of the year.  All revenue is invoiced in South Korean won and
revenues and expenses are translated into United States dollars using
weighted-average exchange rates for the year.





Comprehensive
Income-Other
comprehensive income presented in the accompanying consolidated financial
statements consists of cumulative foreign currency translation
adjustments.





Recently Enacted
Accounting Standards





Business
Combinations - In December 2007, the Financial Accounting Standards Board
issued Statement of Financial Accounting Standards No. 141 (revised 2007),“Business Combinations.”
This accounting principle requires the fundamental requirements of acquisition
accounting (purchase accounting) be applied to all business combinations in
which control is obtained regardless of consideration and for an acquirer to be
identified for each business combination. Additionally, this accounting
principle requires acquisition-related costs and restructuring costs at the date
of acquisition to be expensed rather than allocated to the assets acquired and
the liabilities assumed; minority interests, including goodwill, to be recorded
at fair value at the acquisition date; recognition of the fair value of assets
and liabilities arising from contractual contingencies and contingent
consideration (payments conditioned on the outcome of future events) at the
acquisition date; recognition of bargain purchase (acquisition-date fair value
exceeds consideration plus any noncontrolling interest) as a gain; and
recognition of changes in deferred taxes. This accounting principle will be
adopted January 2009. The accounting requirements will be adopted prospectively.
Earlier adoption is prohibited. Adoption is not expected to have an impact on
our consolidated financial position, results of operations or cash
flows.





Noncontrolling
Interests in Consolidated Financial Statements - In December 2007, the
Financial Accounting Standards Board issued Statement of Financial Accounting
Standards No. 160, “Noncontrolling Interests in Consolidated Financial
Statements.”  This accounting principle eliminates noncomparable
accounting for minority interests. Specifically, minority interests are
presented as a component of shareholders’ equity; consolidated net income
includes amounts attributable to both the parent and minority interest and is
disclosed on the face of the income statement; changes in the ownership interest
are accounted for as equity transactions if ownership remains controlling;
elimination of purchase accounting for acquisitions of noncontrolling interests
and acquisitions of additional interests; and recognition of deconsolidated
controlling interest based on fair value consistent with Statement of Financial
Accounting Standards No. 141 (revised 2007),Business Combinations. This
accounting principle will be adopted January 2009. The accounting requirements
will be adopted prospectively, however presentation and disclosure will be
adopted retrospectively for all periods presented. Earlier adoption is
prohibited. Adoption is not expected to have an impact on our consolidated
financial position, results of operations or cash flows.





Fair Value
Measurements-In September 2006, the FASB issued SFAS No. 157, “Fair Value
Measurements” (“SFAS 157”). SFAS 157 provides guidance for using fair value to
measure assets and liabilities. The standard also responds to investors’ request
for expanded information about the extent to which a company measures assets and
liabilities at fair value, the information used to measure fair value, and the
effect of fair value measurements on earnings. SFAS 157 will be effective for
the Company’s fiscal year beginning January 1, 2008. We are currently reviewing
the effect that the adoption of SFAS 157 will have on our financial
statements.





Results
of Continued Operations





Fiscal
Year 2007 Compared to 2006








30





During 2007, we recorded revenues of
$1,838,000, an increase of $509,000 from $1,329,000 in 2006.  The
increase was primarily due to increased licensing revenue of $287,000, increased
royalties of $324,000, partially offset by decreased non-recurring engineering
speech revenues of $102,000.





Cost of revenues was $141,000, an
increase of $123,000 from $18,000 in 2006.  The increase is primarily
due to the increased costs of third party royalty fees.





Selling, general and administrative
expenses were $2,479,000 in 2007, a decrease of $2,877,000 from $5,356,000 in
2006.  The decrease is primarily due to the decreased bad debt expense
of $1,214,000, decreased salary and wage expenses of $912,000, decreased other
operating expense of $ 328,000, decreased legal and accounting fees of $213,000,
decreased travel expenses of $206,000, decreased promotions of $27,000,
decreased investor relations expenses of $23,000 and decreased depreciation
expenses of $12,000 partially offset by increased occupancy related expenses of
$43,000, increased taxes, licenses and permits of $10,000 and increased
consulting expenses of $5,000.





We incurred research and product
development expenses of $1,572,000 in 2007, a decrease of $571,000 from
$2,143,000 in 2006.  The decrease was primarily due to an overall
decrease in salaries and wage-related expenses of $489,000, decreased occupancy
related expenses of $67,000, decreased travel expenses of $22,000, depreciation
expenses of $15,000, partially offset by increased consulting expenses of
$11,000 and increased other operating expenses of $11,000.





Other income (expense) was a gain of
$19,944,000 for 2007, an increase of $24,452,000 from the expense of $4,508,000
for 2006.  The overall decrease was due to the gain on forgiveness of
liabilities of $21,018,000, primarily resulting for the bankruptcy of the
discontinued subsidiaries of $20,819,000, and a gain on derivative liability of
$813,000 compared to the loss on derivative liability of $2,771,000, increased
gain on forgiveness of liabilities of $199,000, partially offset
by  an increase in interest expense of $150,000.





Fiscal
Year 2006 Compared to 2005





During 2006, we recorded revenues of
$1,329,000, a decrease of $29,000 from $1,358,000 in 2005.  The
decrease was primarily due to decreased non-recurring engineering speech
revenues of $133,000, partially offset by increased royalties of
$104,000.





Cost of revenues was $18,000, a
decrease of $52,000 from $70,000 in 2005.  The decrease is primarily
due to the decreased costs of third party royalty fees.





Selling, general and administrative
expenses were $5,356,000 in 2006, an increase of $594,000 from $4,762,000 in
2005.  The increase is primarily due to the increased bad debt expense
of $1,214,000, increased salary and wage expenses of $143,000, increased
occupancy related expenses of $39,000, increased promotions of $19,000 and
increased consulting expenses of $14,000, partially offset by decreased legal
and accounting fees of $377,000, decreased other operating expense of $ 261,000,
decreased investor relations expenses of $84,000, decreased travel expenses of
$63,000, decreased taxes, licenses and permits of $48,000 and decreased
depreciation expenses of $2,000.





We incurred research and product
development expenses of $2,143,000 in 2006, a decrease of $53,000 from
$2,196,000 in 2005.  The decrease was primarily due to an overall
decreased consulting expenses of $74,000 and decreased other operating expenses
of $27,000, partially offset by increased occupancy related expenses of $21,000,
increased travel expenses of $14,000 and increase in salaries and wage-related
expenses of $13,000.





Net interest and other income and
expense was $4,508,000 for 2006, an increase of $3,464,000 from $1,044,000 for
2005.  The overall increase was due to the loss on derivative
liability of $2,771,000, increase in interest expense of $439,000, decreased
gain on forgiveness of liabilities of $142,000, decreased gain on sale of
investments of $104,000 and decreased interest income of $8,000.





Selected
Quarterly Operations Data








31





The following tables set forth selected
unaudited statement of operations data for each of the quarters in the years
ended December 31, 2007 and 2006.  This data has been derived from our
unaudited financial statements that have been prepared on the same basis as the
audited financial statements and, in the opinion of management, include all
adjustments, consisting of normal recurring adjustments, necessary for a fair
presentation of the information when read in connection with the financial
statements and the related notes.  Our quarterly operating results
have varied substantially in the past and may vary substantially in the
future.  Conclusions about our future results for any period should
not be drawn from the selected unaudited statement of operations data, either
for any particular quarter or taken as a whole.





For
      the Quarter EndedMar
      31, 2007
            
            
            Jun
      30, 2007
            
            
            Sep
      30, 2007
            
            
            Dec
      31, 2007(Unaudited)Net
      sales
            
            $
            360,000
            
            
            $
            644,000
            
            
            $
            339,000
            
            
            $
            495,000Gross
      profit
            
            
            353,000
            
            
            
            572,000
            
            
            
            285,000
            
            
            
            487,000Net
      gain/loss from continuing operations
            
            
            (787,000
            )
            
            
            (1,061,000
            )
            
            
            (585,000
            )
            
            
            17,392,000Preferred
      stock dividends
            
            
            (410,000
            )
            
            
            (431,000
            )
            
            
            (434,000
            )
            
            
            (427,000
            )Net
      gain/loss attributable to common stockholders
            
            
            (1,197,000
            )
            
            
            (1,492,000
            )
            
            
            (1,019,000
            )
            
            
            16,965,000Basic
      gain (loss) per common share
            
            $
            (0.00
            )
            
            $
            (0.00
            )
            
            $
            (0.00
            )
            
            $
            0.01Diluted
      gain per common share
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            $
            0.00








For
      the Quarter EndedMar
      31, 2006
            
            
            Jun
      30, 2006
            
            
            Sep
      30, 2006
            
            
            Dec
      31, 2006(Unaudited)Net
      sales
            
            $
            272,000
            
            
            $
            366,000
            
            
            $
            386,000
            
            
            $
            305,000Gross
      profit
            
            
            267,000
            
            
            
            365,000
            
            
            
            380,000
            
            
            
            299,000Net
      loss from continuing operations
            
            
            (1,851,000
            )
            
            
            (1,849,000
            )
            
            
            (4,486,000
            )
            
            
            (2,510,000
            )Net
      loss from discontinued operations
            
            
            (2,230,000
            )
            
            
            (2,656,000
            )
            
            
            (6,361,000
            )
            
            
            --Preferred
      stock dividends
            
            
            (1,849,000
            )
            
            
            (254,000
            )
            
            
            (16,192,000
            )
            
            
            (440,000
            )Net
      loss attributable to common stockholders
            
            
            (5,930,000
            )
            
            
            (4,759,000
            )
            
            
            (27,039,000
            )
            
            
            (2,950,000
            )Basic
      and diluted loss per common share
            
            $
            (0.01
            )
            
            $
            (0.01
            )
            
            $
            (0.01
            )
            
            $
            (0.01
            )





Liquidity
and Capital Resources





We must raise additional funds to be
able to satisfy our cash requirements during the next 12 months.  It
is anticipated that we will need to raise approximately $2 to $3 million over
the next 12 months to meet obligations and continue our product development,
corporate operations and marketing expenses.  Because we presently
have only limited revenue from operations, we intend to continue to rely
primarily on financing through the sale of our equity and debt securities to
satisfy future capital requirements until such time as we are able to enter into
additional third-party licensing, collaboration, or co-marketing arrangements
such that we will be able to finance ongoing operations from license, royalty,
and sales revenue.  We are working with game developers and other
potential licensors of our speech product offerings to develop additional
revenue streams for our speech technologies.  There can be no
assurance that we will be able to enter into such
agreements.  Furthermore, the issuance of equity or debt securities
which are or may become convertible into equity securities of Fonix in
connection with such financing could result in substantial additional dilution
to the stockholders of Fonix.








32





Our cash resources are limited to
collections from customers, proceeds from the issuance of preferred stock, and
loan proceeds, and are only sufficient to cover current operating expenses and
payments of current liabilities.  At December 31, 2007, we had
negative working capital of $34,384,000, derivative liabilities of $20,742,000
related to the issuance of Series L Preferred Stock,  Series M
Preferred Stock, Series N Preferred Stock,  Series E Convertible
Debentures and Fonix Speech Series B Preferred Stock, accrued liabilities and
accrued settlement obligation of $5,045,000, accounts payable of $1,532,000 and
current portion of notes payable of $3,833,000, Series E debentures of
$1,754,000 and deferred revenues of $445,000.





We had $1,838,000 in revenue and net
income of $14,959,000 for the year ended December 31, 2007.  Net cash
used in operating activities of $2,312,000 for the year ended December 31, 2007,
resulted principally from the net gain incurred of $14,959,000, the gain on
forgiveness of liabilities of $21,018,000, the gain on derivative liability of
$813,000, decreased deferred revenues of $15,000, decreased accrued payroll of
$3,000, partially offset by the impairment of goodwill of $2,361,000, non-cash
accretion of the discount on notes payable of $1,068,000, increased other
accrued liabilities of $805,000, depreciation expense of $32,000, increased
accounts payable of $28,000, decreased other assets of $9,000, and decreased
prepaid expenses and other current assets of $5,000, and.  Net cash
used in investing activities was zero for the year ended December 31,
2007.  Net cash provided by financing activities of $2,333,000
consisting primarily of the receipt of $1,350,000 in cash related to the sale of
shares of Series N preferred stock, the receipt of $1,250,000 in cash related to
the sale of shares of Fonix Speech Series B preferred stock, proceeds from notes
payable of $450,000 and $102,000 in proceeds from related party notes, partially
offset by payments on accrued settlement obligation of $819,000.





We had negative working capital of
$34,384,000 at December 31, 2007, compared to negative working capital of
$52,957,000 at December 31, 2006.  Current assets increased by $78,000
to $87,000 from $9,000 from December 31, 2006, to December 31,
2007.  Current liabilities decreased by $18,495,000 to $34,471,000
from $52,966,000 during the same period.  The change in working
capital from December 31, 2006, to December 31, 2007, reflects, in part, the
derivative related to the issuance of Series L Preferred
Stock,  Series M Preferred Stock, Series N Preferred
Stock,  Series E Convertible Debentures and Fonix Speech Series B
Preferred Stock,  the gain on forgiveness of liabilities of which
$20,819,000 is related to discontinued operations, and increases in current
portion of notes payable, accrued liabilities and accounts payable, partially
offset by decreases in accrued settlement obligation due to payments made during
the year ended December 31, 2007.  Total assets were $211,000 at
December 31, 2007, compared to $2,805,000 at December 31, 2006.





Notes
Payable Related Parties





During
2002, two of our then executive officers, Roger D. Dudley and Thomas A. Murdock
(the “Lenders”) sold shares of our Class A common stock owned by them and
advanced the resulting proceeds amounting to $333,000 to us under the terms of a
revolving line of credit and related promissory note.  The funds were
advanced for use in our operations.  The advances bear interest at 12
percent per annum, which interest is payable on a semi-annual
basis.  The entire principal, along with unpaid accrued interest and
any other unpaid charges or related fees, was originally due and payable on June
10, 2003.  Fonix and the Lenders have agreed to postpone the maturity
date on several occasions.  The note was due September 30,
2006.  All or part of the outstanding balance and unpaid interest may
be converted at the option of the Lenders into shares of Class A common stock of
Fonix at any time.  The conversion price was the average closing bid
price of the shares at the time of the advances.  To the extent the
market price of our shares is below the conversion price at the time of
conversion, the Lenders are entitled to receive additional shares equal to the
gross dollar value received from the original sale of the shares.  The
Lenders may also receive additional compensation as determined appropriate by
the Board of Directors.





In October 2002, the Lenders pledged
30,866 shares of the Company's Class A common stock to the Equity Line Investor
in connection with an advance of $183,000 to us under the Third Equity
Line.  The Equity Line Investor subsequently sold the pledged shares
and applied $82,000 of the proceeds as a reduction of the
advance.  The value of the pledged shares of $82,000 was treated as an
additional advance from the Lenders.








33





During 2004, we entered into an
agreement with the holders of the promissory note to increase the balance of the
note payable by $300,000 in exchange for a release of the $1,443,000 of accrued
liabilities related to prior indemnity agreements between us and the note
holders.  We classified the release of $1,143,000 as a capital
contribution in the Consolidated Financial Statements during the fourth quarter
of 2004.  We made principal payments against the note of $253,000
during the year ended December 31, 2004.  During the year ended
December 31, 2005, we received an additional advance of $50,000 under the note
from the Lenders.  The balance due the Lenders at December 31, 2005,
was $486,000.  For the year ended December 31, 2006, we received
additional advances and other consideration from the Lenders in the aggregate
amount of $419,000 and made principal payments to the Lenders against the note
of $105,000.  During the year ended December 31, 2007, the Company
received additional advances of $102,000.  The balance due at
September 30, 2007, was $902,000.





The aggregate advances of $902,000 are
secured by the Company’s intellectual property rights and stock of Fonix
Speech.  As of  December 31, 2007, the Lenders had not
converted any of the outstanding balance or interest into common
stock.  However, on March 24, 2008, the Lenders converted $10,000 into
53,913,701shares of our common stock for the benefit of one of the Lenders,
Thomas A. Murdock.





Notes
Payable





During the first quarter of 2003, we
entered into a promissory note with an unrelated third party converting accounts
payable for outstanding lease payments of $114,000 to a note
payable.  This note accrued interest at 10% annually and required
monthly minimum payments of the greater of $3,000 or 2% of aggregate proceeds
from our Third Equity Line of Credit and subsequent equity lines of credit until
the note was been fully paid.  Under the loan agreement, we could not
sell or transfer assets outside of the ordinary course of business, or enter a
transaction resulting in a change of control, without written permission from
the creditor.  The note was paid in full during the year ended
December 31, 2004.





On February 28, 2003, LecStar
established an asset securitization facility which provided LecStar with
$750,000.  Assets securitized under this facility consist of executory
future cash flows from LecStar customers in the states of Georgia, Tennessee,
Florida, and Louisiana.  LecStar has pledged its interest in the
special purpose securitization facility, LecStar Telecom Ventures LLC, and
customer accounts receivable to the lender.  We have recorded the
$750,000 as a note payable in our consolidated financial
statements.  The note bears an interest rate of 6.5% and is due on
February 27, 2007, with 24 equal monthly installments which began on March 6,
2005.  During 2005, we made principal payments of
$214,000.





In connection with the acquisition of
the capital stock of LTEL Holdings in 2004, we issued a 5%, $10,000,000,
secured, six-year note (the “Note”) payable to McCormack Avenue, Ltd.
(“McCormack”).  Under the terms of the Note, quarterly interest only
payments were required through January 15, 2005, with quarterly principal and
interest payments beginning April 2005 and continuing through January
2010.  Interest on the Note is payable in cash or, at our option, in
shares of our Class A common stock.  The Note is secured by the
capital stock and all of the assets of LTEL Holdings and its
subsidiaries.  The Note was valued at $4,624,000 based on an imputed
interest rate of 25 percent per annum.





The discount on the Note is based on an
imputed interest rate of 25%.  The carrying amount of the Note of
$5,542,000 at December 31, 2006, was net of unamortized discount of
$3,191,000.  As of the date of this Report, we had not made any
scheduled payments for 2006 or 2007.





On September 8, 2006, we received a
default notice (the “Default Notice”) from McCormack in respect of the
Note.  Under the terms of the Note, and a related Security Agreement
between us and McCormack dated February 24, 2004 (the “Security Agreement”),
McCormack may declare all liabilities, indebtedness, and obligations of Fonix to
McCormack under the Security Agreement and the Note immediately due and owing
upon an event of default.  The Note defines an event of default to
include the non-payment by us of a scheduled payment which is not cured within
60 days.





In the
Default Notice, McCormack stated that it intended to exercise its rights,
including any and all rights set forth in the Note as amended.








34





Also on
September 8, 2006, McCormack provided to us a Notice of Sale, stating
McCormack’s intention to sell at public auction all of the collateral referred
to in the Security Agreement, consisting of the capital stock and assets of
LecStar Telecom, LecStar DataNet and LTEL Holdings.  To date, no sale
of the assets or capital stock of LecStar Telecom, LecStar DataNet nor LTEL
Holdings has occurred.





McCormack
has notified us that notwithstanding the Series L Exchange Agreement between us
and McCormack discussed above, McCormack has not waived any of its rights in
connection with the Note, the Modification Agreement, the Security Agreement, or
the Supplemental Security Agreement.





During 2005, we entered into two
promissory notes with an unrelated third party in the aggregate amount of
$650,000.  These notes accrue interest at 10% annually and were due
and payable during May and June of 2006.  These notes were exchanged
in December 2006 for the Southridge Debenture discussed below.





During the third quarter of 2006, we
entered into a debenture agreement with an unrelated third party for
$619,000.  The debenture accrues interest at 9% annually and was due
and payable on September 30, 2006.  This debenture was exchanged in
December 2006 for the Southridge Debenture discussed below.





Series
D Debentures





On October 11, 2002, we issued
$1,500,000 of Series D 12% Convertible Debentures (the "Debentures"), due April
9, 2003, and 194,444 shares of Class A common stock to Breckenridge Fund, LLC
("Breckenridge"), an unaffiliated third party, for $1,500,000 before offering
costs of $118,000.  The outstanding principal amount of the Debentures
was convertible at any time at the option of the holder into shares of our
common stock at a conversion price equal to the average of the two lowest
closing bid prices of our Class A common stock for the twenty trading days
immediately preceding the conversion date, multiplied by 90%.





We determined that Breckenridge had
received a beneficial conversion option on the date the Debentures were
issued.  The net proceeds of $1,382,000, were allocated to the
Debentures and to the Class A common stock based upon their relative fair values
and resulted in allocating $524,000 to the Debentures, $571,000 to the related
beneficial conversion option, $373,000 to the 194,444 shares of Class A common
stock, less $86,000 of deferred loan costs.  The resulting $976,000
discount on the Debentures and the deferred loan costs were amortized over the
term of the Debentures as interest expense.





The Debentures were originally due
April 9, 2003.  However, Fonix and Breckenridge agreed in January 2003
to modify the terms of the Debentures requiring the following principal payments
plus accrued interest: $400,000 in January 2003; $350,000 in February 2003;
$250,000 in March 2003; $250,000 in April 2003; and $250,000 in May
2003.  Additionally, we agreed to release 237,584 of the Collateral
Shares to Breckenridge as consideration (the "Released Shares") for revising the
terms of the purchase agreement.  The additional shares were accounted
for as an additional discount of $285,000.  The value of the shares
was amortized over the modified term of the Debentures as interest
expense.  We did not make the last three payments as
scheduled.  Breckenridge asserted its rights under the Debenture
agreement for penalties as we did not meet the prescribed payment
schedule.  Breckenridge asserted a claim of $379,000 which we
disputed.  Both parties subsequently agreed to satisfy the claim in
full through the issuance of 1,550,000 shares of our Class A common stock with a
value of $225,000.  We transferred the shares to Breckenridge on
October 20, 2003, in full satisfaction of the claim and recorded the penalty as
interest expense.





In connection with the issuance of the
Debentures, we entered into a registration rights agreement in which we agreed
to register the resale of the shares underlying the Debentures, the Collateral
Shares, and the Released Shares.  We filed a registration statement on
Form S-2, which became effective February 14, 2003.  Additionally, we
filed another registration statement on July 2, 2003, which was declared
effective on July 7, 2003, which included shares issuable to Breckenridge in
connection with the Debentures.  We were obligated to file such
post-effective amendments as necessary to keep the registration statements
effective as required by the registration rights agreement.








35





Through December 31, 2003, we had paid
$650,000 of the outstanding principal, together with $54,000 in accrued
interest.  Additionally, through December 31, 2003, the holder of the
Debentures converted the remaining $850,000 principal amount and $41,000 in
interest into 7,359,089 shares of Fonix Class A common stock.





As part of the Debenture agreement, we
were required to pay Breckenridge a placement fee in the amount of $350,000
payable in stock at the conclusion of the Debenture.  We satisfied the
obligation through the issuance of 2,000,000 shares of our Class A common stock
valued at $358,000, or $0.179 per share and 377,717 shares of our Class A common
stock valued at $59,000, or $0.157 per share.  We recorded the expense
as interest expense.





In March 2004, we discovered that
during 2003 an aggregate of 2,277,777 shares of Class A common stock (the
"Unauthorized Shares") were improperly transferred to the Debenture holder as a
result of (i) the unauthorized release from escrow of the Collateral Shares (net
of the Released Shares), and (ii) the transfer to the Debenture holder of a
duplicate certificate for 194,445 shares where the original certificate was not
returned to the transfer agent for cancellation.  The Unauthorized
Shares were, therefore, in excess of the shares the Debenture holder was
entitled to receive.  No consideration was paid to or received by us
for the Unauthorized Shares during 2003; therefore, we did not recognize the
Unauthorized Shares as being validly issued during 2003.





Upon discovering in March 2004 that the
Unauthorized Shares had been improperly transferred to the Debenture holder, we
attempted to settle the matter with the Debenture holder but was unable to reach
a settlement.  Accordingly, on May 3, 2004, we filed a lawsuit against
the Debenture holder, alleging the improper transfer to and subsequent sale of
the Unauthorized Shares by the Debenture holder.  The lawsuit was
subsequently dismissed without prejudice and refiled on October 12,
2004.  The complaint sought (i) a declaratory judgment that we may set
off the fair value of the Unauthorized Shares against the value we owed to the
Debenture holder in connection with the Series I Preferred Stock transaction,
(ii) judgment against the Debenture holder for the fair value of the
Unauthorized Shares, and (iii) punitive damages from the Debenture holder for
improper conversion of the Unauthorized Shares.




On
September 27, 2005, we agreed with Breckenridge to settle and discontinue the
three pending legal actions between us and Breckenridge.  The three
actions pending in the Supreme Court of New York, Nassau County, involved (i)
the Company’s claims against Breckenridge for the improper transfer to and
subsequent sale of shares of the Company’s common stock by Breckenridge; (ii)
Breckenridge’s claims against the Company for failure to honor conversion
notices or properly issue shares upon conversion of the Company’s Series I 8%
Convertible Preferred Stock (the “Series I Preferred”) by Breckenridge; and
(iii) Breckenridge’s claims that the Company breached agreements in connection
with the Series I Preferred, and that pursuant to a security agreement,
Breckenridge was entitled to damages and possession of the pledged collateral
(collectively, the “Breckenridge Lawsuits”).





Pursuant to the Settlement of the
Breckenridge Lawsuits, we entered into a Mutual Release of Claims Agreement (the
“Mutual Release”), pursuant to which we and Breckenridge agreed to settle and
dismiss the Breckenridge Lawsuits, and to release any and all claims against
each other relating to any prior transactions between us and
Breckenridge.  Pursuant to the Mutual Release, Breckenridge agreed to
assign the remaining shares of Series I Preferred to Southridge Partners, LP, to
release its security interest in the Company’s intellectual property, and to
stipulate to the discontinuance with prejudice of the Breckenridge
Lawsuits.  We agreed to pay to Breckenridge installment payments (the
“Periodic Payments”) consisting of monthly payments of $130,000 from November
2005 through April 2006, and monthly payments of $165,000 from May 2006 through
December 2006, as well as approximately $397,000 which we had previously paid
into an escrow account in connection with the Breckenridge
Lawsuits.





On June 6, 2006, Breckenridge filed a
complaint against the Company in the Supreme Court of the State of New York,
County of Nassau (the “Court”), in connection with a settlement agreement
between the Company and Breckenridge entered into in September 2005. In the
Complaint, Breckenridge alleged that the Company failed to pay certain amounts
due under the settlement agreement in the amount of $450,000. The Company denied
the allegations of Breckenridge’s complaint and filed a motion for summary
judgment.  Breckenridge also filed for summary judgment on its
complaint.








36





On February 2, 2007, the Court granted
Breckenridge’s motion for summary judgment, denied the Company’s summary
judgment motion, and directed that a hearing be held to determine the amount
owed by the Company to Breckenridge.  The Company and Breckenridge
entered into a stipulation that the Company owed Breckenridge $1,530,000 plus
interest at a rate of 9% from September 15, 2006 to the date of entry of
judgment.





The
Court’s judgment dated as of March 15, 2007, states that the Company owes an
aggregate of $1,602,000 to Breckenridge.  The Company has accrued for
this settlement in the accompanying financial statements.





In
February 2008, the Company entered into an amended settlement agreement with
Breckenridge under which the Company agreed to pay Breckenridge
$540,000.  The Company has paid Breckenridge $242,500 and is obligated
to pay the balance of $297,500 at the rate of $42,500 per month.





Equity
Lines of Credit





We have previously entered into several
equity lines of credit with Queen, LLC (the “Equity Line
Investor”).  The two most recent were the Sixth Equity Line of Credit
and the Seventh Equity Line of Credit.





Sixth Equity Line
of Credit– As of November 15, 2004, we entered into a sixth private
equity line agreement (the "Sixth Equity Line Agreement") with the Equity Line
Investor, on terms substantially similar to those of the previous equity
lines.  Under the Sixth Equity Line Agreement, we had the right to
draw up to $20,000,000 against an equity line of credit ("the Sixth Equity
Line") from the Equity Line Investor.  We were entitled under the
Sixth Equity Line Agreement to draw certain funds and to put to the Equity Line
Investor shares of our Class A common stock in lieu of repayment of the
draw.  The number of shares to be issued was determined by dividing
the amount of the draw by 90% of the average of the two lowest closing bid
prices of our Class A common stock over the ten trading days after the put
notice was tendered.





The Equity Line Investor was required
under the Sixth Equity Line Agreement to tender the funds requested by us within
two trading days after the ten-trading-day period used to determine the market
price.





In connection with the Sixth Equity
Line Agreement, we granted registration rights to the Equity Line Investor and
filed a registration statement on Form S-2, which covered the resales of the
shares to be issued under the Sixth Equity Line.  We are obligated to
maintain the effectiveness of the registration statement.





For the year ended December 31, 2005,
we received $4,263,000 in funds drawn under the Sixth Equity Line, less
commissions and fees of $141,000 and issued 75,000,000 shares of Class A common
stock to the Equity Line Investor.





Seventh Equity
Line of Credit - On May 27, 2005, we entered into a seventh private
equity line agreement (the "Seventh Equity Line Agreement") with the Equity Line
Investor, on terms substantially similar to those of the Sixth Equity Line
between Queen and us dated November 15, 2004.





Under the
Seventh Equity Line Agreement, we had the right to draw up to $20,000,000
against an equity line of credit (the "Seventh Equity Line") from the Equity
Line Investor.  We were entitled under the Seventh Equity Line
Agreement to draw certain funds and to put to the Equity Line Investor shares of
the Company's Class A common stock in lieu of repayment of the
draw.  We were limited as to the amount of shares we may put to the
Equity Line Investor in connection with each put; we could not put shares which
would cause the Equity Line Investor to own more than 4.99% of our outstanding
common stock on the date of the put notice.  The number of shares to
be issued in connection with each draw was determined by dividing the amount of
the draw by 93% of the average of the two lowest closing bid prices of our Class
A common stock over the ten trading days after the put notice is
tendered.  The Equity Line Investor was required under the Seventh
Equity Line Agreement to tender the funds requested by us within two trading
days after the ten-trading-day period used to determine the market
price.








37





We granted registration rights to the
Equity Line Investor and filed three registration statements which cover the
resales of the shares to be issued under the Seventh Equity Line.  All
of the shares registered by the first registration statement had been sold as of
October 24, 2005.  The second registration statement filed in
connection with the Seventh Equity Line was declared effective by the SEC on
February 10, 2006.  All of the shares registered by the second
registration statement had been sold as of July 26, 2006.  We filed a
third registration statement on June 26, 2006, to register additional shares
under the Seventh Equity Line.  However, that registration statement
was not declared effective, and no shares were sold under that registration
statement.





For the
year ended December 31, 2005, we received $3,127,000 in funds drawn under the
Seventh Equity Line, less commissions and fees of $106,000.  We issued
100,000,000 shares of Class A common stock to the Equity Line Investor as puts
under the Seventh Equity Line totaling $3,127,000.





For the
year ended December 31, 2006, we received $3,378,000 in funds drawn under the
Seventh Equity Line, less commissions and fees of $114,000.  We issued
300,000,000 shares of Class A common stock to the Equity Line Investor as puts
under the Seventh Equity Line totaling $3,378,000.





In January 2007, we terminated the
Seventh Equity Line, and we have withdrawn the third registration statement
related to the Seventh Equity Line.  As such, as of the date of this
report, we did not have an equity line of credit financing available to
us.





Stock Options and
Warrants





For the year ended December 31, 2007,
we granted no options to employees to purchase.  As of December 31,
2007, we had a total of 376,500 options to purchase Class A common stock
outstanding.





On January 19, 2005 we entered into an
option exchange program with our employees, wherein we gave eligible Fonix
employees the opportunity to exchange outstanding stock options for the same
number of new options to be issued at least six months and one day from the
expiration of the offer.  As a result of the option exchange program,
we cancelled 414,450 options to purchase shares of our Class A common stock
effective February 22, 2005.  On August 23, 2005 we granted 414,450
options to employees participating in the option exchange program at $0.04 per
share.





During 2005, we granted options to
purchase 746,505 shares of Class A common stock in addition to the option
granted in connection with the option exchange program described
above.  The options were granted at exercise prices ranging from $0.04
to $0.12.  All options were granted at the quoted market price on the
date of grant.  All options granted vest over three years following
issuance.  If not exercised, all options expire within ten years from
the date of grant.





During 2006, we granted options to
purchase 58,000 shares of Class A common stock in addition to the option granted
in connection with the option exchange program described above.  The
options were granted at exercise prices ranging from $0.01 to
$0.02.  All options were granted at the quoted market price on the
date of grant.  All options granted vest over three years following
issuance.  If not exercised, all options expire within ten years from
the date of grant.





As of December 31, 2007, we had
warrants to purchase a total of 15,000 shares of Class A common stock
outstanding that expire through 2010.





Summary
of Contractual Obligations





The following summary reflects payments
due under long-term obligations as of December 31, 2007:





Total
            
            
            Less Than One
            
            
            One to Three
            
            
            Three to Five
            
            
            More than FiveNotes
      payable
            
            $
            11,166,000
            
            
            $
            4,735,000
            
            
            $
            6,431,000
            
            
            $
            --
            
            
            
            --Operating
      lease obligations
            
            
            832,000
            
            
            
            312,000
            
            
            
            520,000
            
            
            
            --
            
            
            
            --Series
      E debentures
            
            
            1,755,000
            
            
            
            -- --
            
            
            
            --
            
            
            
            1,755,000
            
            
            
            --Preferred
      stock dividends
            
            
            8,900,000
            
            
            
            1,780,000
            
            
            
            3,560,000
            
            
            
            3,560,000
            
            
            
            **Total
      contractual cash obligations
            
            $
            22,653,000
            
            
            $
            6,827,000
            
            
            $
            10,511,000
            
            
            $
            5,315,000




**  Preferred
stock dividends do not have a definite life, therefore dividend payment
requirements greater than five years cannot reasonably be
estimated.










38





Other





We presently have no plans to purchase
new research and development or office facilities.





Corporate
Outlook





Fonix’s
focus on providing competitive and value-added solutions for customers and
partners requires a broad set of technologies, service offerings and channel
capabilities.  Management anticipates and expects further development
of complementary technologies, added product and application developments,
access to market channels and additional opportunities for strategic alliances
in other industry segments.





We will
continue to leverage our research and development of speech technologies to
deliver software applications and engines to device manufacturers looking to
incorporate speech interfaces into end-user products.  Fonix Speech’s
award-wining technologies provide competitive embedded speech solutions for
mobile/wireless devices, videogames, telephony systems and products for the
assistive market based on Fonix’s proprietary and patented TTS and ASR
technologies.





As we proceed to implement our strategy
and to reach our objectives, we anticipate further development of complementary
technologies, added product and applications development expertise, access to
market channels and additional opportunities for strategic alliances in other
industry segments.  The strategy adopted by us has significant risks,
and shareholders and others interested in Fonix and our Class A common stock
should carefully consider the risks set forth below and under the heading
“Certain Significant Risk Factors” in Item 1, Part I, of this
report.





As noted above, as of December 31,
2007, we had an accumulated deficit of $277,943,000, negative working capital of
$34,384,000, derivative liabilities of $20,742,000 related to the issuance of
Series L Preferred Stock,  Series M Preferred Stock, Series N
Preferred Stock,  Series E Convertible Debentures and Series B
Preferred Stock of our subsidiary, accrued liabilities and accrued settlement
obligation of $5,045,000, accounts payable of $1,532,000 and current portion of
notes payable of $3,833,000, Series E debentures of $1,754,000 and deferred
revenues of $445,000.  Further, on March 15, 2007, the New
York State trial court entered the Breckenridge Judgment in the amount of
$1,602,000.  However, we have entered into a settlement agreement to
pay the balance due Breckenridge under the Breckenridge Judgment of $297,500 at
the rate of $42,500 for seven consecutive months.  As of the date of
this report the balance owed was $255,000.  Sales of products and
revenue from licenses based on our technologies have not been sufficient to
finance ongoing operations.  These matters raise substantial doubt
about our ability to continue as a going concern.  Our continued
existence is dependent upon several factors, including our success in (1)
increasing speech license, royalty and services revenues, (2) raising sufficient
additional funding, and (3) minimizing operating costs.  Until
sufficient revenues are generated from operating activities, we expected to
continue to fund our operations through debt instruments.  We are
currently pursuing additional sources of liquidity in the form of traditional
commercial credit, asset based lending, or additional sales of our equity
securities to finance our ongoing operations.  Additionally, we are
pursuing other types of commercial and private financing, which could involve
sales of our assets or sales of one or more operating divisions.  Our
sales and financial condition have been adversely affected by our reduced credit
availability and lack of access to alternate financing because of our
significant ongoing losses and increasing liabilities and
payables.  As we have noted in our previous annual reports and other
public filings, if additional financing is not obtained in the near future, we
will be required to more significantly curtail our operations or seek protection
under bankruptcy laws.





As
discussed in other sections of this Annual Report, on Wednesday, March 5, 2008,
Thomas A. Murdock resigned as Chairman of the Board, President, and Chief
Executive Officer of the Company.  Mr. Murdock also resigned all
officer and director positions he held with Fonix Speech, Inc., Fonix/AcuVoice,
Inc., Fonix/Papyrus Corporation, Fonix UK, Ltd., and Fonix Sales, Korea Group,
Ltd., all subsidiaries of the Company.  Additionally, on Wednesday,
March 5, 2008, William A. Maasberg resigned as director of the Company, on
Friday, March 31, 2008, Mr. Maasberg resigned as the Company’s Chief Operating
Officer.





In connection with the resignation of
Messrs. Murdock and Maasberg, the Company appointed Roger D. Dudley, who was
serving as the Company’s Executive Vice President and Chief Financial Officer,
as the Company’s Chairman, President, and Chief Executive
Officer.  Mr. Dudley will continue to serve as Chief Financial
Officer.  Following the resignations of Messrs. Murdock and Maasberg,
Mr. Dudley is the sole director and sole executive officer of the
Company.





39





Information
Concerning Forward-Looking Statements





Certain of the statements contained in
this report (other than the historical financial data and other statements of
historical fact) are forward-looking statements.  These statements
include, but are not limited to our expectations with respect to the development
of a diversified revenue base; delivery of our VoiceDial application; the market
volume of educational electronic dictionary devices; our ability to capitalize
in markets including toys, appliances, and other devices; the market demand for
videogames; our growth strategies and the implementation of our Core
Technologies and potential results; our payment of dividends on our common
stock; our ability to meet customer demand for speech technologies and
solutions; development of complementary technologies, products, marketing, and
strategic alliance opportunities; profitability of language learning tools; the
status of  traditional operator systems; our ability to continue
operations in the event we do not receive approval to amend our articles of
incorporation; the comparability of our speech-enabled Speech Products to other
products; our intentions with respect to strategic collaborations and marketing
arrangements; our intentions with respect to use of licenses; our plans with
respect to development and acquisition of speech solutions; our goals with
respect to supplying speech solutions for OEMs; our expectations with respect to
continued financial losses; and our intentions with respect to financing our
operations in the future.  Additional forward-looking statements may
be found in the “Certain Significant Risk Factors” Section of this Report,
together with accompanying explanations of the potential risks associated with
such statements.





Forward-looking statements made in this
Report are made based upon management’s good faith expectations and beliefs
concerning future developments and their potential effect upon
Fonix.  There can be no assurance that future developments will be in
accordance with such expectations, or that the effect of future developments on
Fonix will be those anticipated by management.  Forward-looking
statements may be identified by the use of words such as “believe,” “expect,”
“plans,” “strategy,” “prospects,” “estimate,” “project,” “anticipate,” “intends”
and other words of similar meaning in connection with a discussion of future
operating or financial performance.





You are cautioned not to place undue
reliance on these forward looking statements, which are current only as of the
date of this Report.  We disclaim any intention or obligation to
update or revise any forward-looking statements, whether as a result of new
information, future events, or otherwise.  Many important factors
could cause actual results to differ materially from management’s expectations,
including those listed in the “Certain Significant Risk Factors” Section of this
report, as well as the following:





•
            unpredictable
      difficulties or delays in the development of new products and
      technologies;





•
            changes
      in U.S. or international economic conditions, such as inflation, interest
      rate fluctuations, foreign exchange rate fluctuations or recessions in
      Fonix's markets;





•
            pricing
      changes to our supplies or products or those of our competitors, and other
      competitive pressures on pricing and
sales;





•
            difficulties
      in obtaining or retaining the management, engineering, and other human
      resource competencies that we need to achieve our business
      objectives;





•
            the
      impact on Fonix or a subsidiary from the loss of a significant customer or
      a significant number of customers;





•
            risks
      generally relating to our international operations, including
      governmental, regulatory or political
changes;





•
            transactions
      or other events affecting the need for, timing and extent of our capital
      expenditures; and





•
            the
      extent to which we reduce outstanding
debt.











40





ITEM
      7A.
            QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK





We
believe our exposure to overall foreign currency risk is not
material.  We do not manage or maintain market risk sensitive
instruments for trading or other purposes and are not exposed to the effects of
interest rate fluctuations as all of our debt has fixed interest
rates.





We report
our operations in US dollars and our currency exposure, although considered by
us as immaterial, is primarily between the US dollar and the Japanese
Yen.  Exposure to other currency risks is also not material as
international transactions are settled in US dollars.  Any future
financing undertaken by us will be denominated in US dollars.  In
addition, all of our bank deposits are maintained in U.S. dollars.





ITEM
      8.
            FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA




Index
      to Consolidated Financial Statements:Report
      of Independent Registered Public Accounting Firm
              F-2CONSOLIDATED
      FINANCIAL STATEMENTS:Consolidated
      Balance Sheets as of December 31, 2007 and 2006
              F-3Consolidated
      Statements of Operations and Comprehensive Loss for the Years Ended
      December 31, 2007, 2006 and 2005
              F-4Consolidated
      Statements of Stockholders’ Deficit for the Years Ended December 31, 2005,
      2006 and 2007
              F-5Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2007, 2006 and
      2005
              F-6Notes
      to Consolidated Financial Statements
              F-8













41





ITEM
      9A.
            CONTROLS
      AND PROCEDURES







Management's
Report on Internal Control Over Financial Reporting






Our
management is responsible for establishing and maintaining effective internal
control over financial reporting. Internal control over financial reporting is
defined in Rule 13a-15(f) or Rule 15d-(f) promulgated under the
Exchange Act as a process designed by, or under the supervision of, a company's
principal executive officer and principal financial officer and effected by the
company's board of directors, management and other personnel, to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that:




•
            pertain
      to the maintenance of records that, in reasonable detail, accurately and
      fairly reflect the transactions and dispositions of the assets of the
      company;


•
            provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the company
      are being made only in accordance with authorizations of management and
      directors of the company; and


•
            provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use or disposition of the company's assets that
      could have a material effect on the financial
  statements.




Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.






Our
management assessed the effectiveness of our internal control over financial
reporting as of December 31, 2007. In making its assessment, management
used the criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission. Based on its assessment, management determined that, as of
December 31, 2007, we maintained effective internal control over financial
reporting based on those criteria.




Evaluation of Disclosure
Controls and Procedures.  Our Chief Executive Officer and our
Chief Financial Officer, after evaluating the effectiveness of the Company’s
“disclosure controls and procedures” (as defined in the Securities Exchange Act
of 1934 (Exchange Act) Rules 13a-15(e) or 15d-15(e)) as of the end of the period
covered by this annual  report, have concluded that our disclosure
controls and procedures are effective based on their evaluation of these
controls and procedures required by paragraph (b) of Exchange Act Rules 13a-15
or 15d-15.





Changes in Internal Control
Over Financial Reporting.  There were no changes in our
internal control over financial reporting identified in connection with the
evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that
occurred during our last fiscal quarter that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.





Section 404
Assessment.  Section 404 of the Sarbanes-Oxley Act of 2002
requires management’s annual review and evaluation of our internal controls
beginning with our Form 10-K for the fiscal year ending December 31, 2007, and
an attestation of the effectiveness of these controls by our independent
registered public accounting firm beginning with our Form 10-K for the fiscal
year ending on December 31, 2008.  We are dedicating significant
resources, including management time and effort, and incurring substantial costs
in connection with our ongoing Section 404 assessment.  We are
currently documenting and testing our internal controls and considering whether
any improvements are necessary for maintaining an effective control environment
at our company.  The evaluation of our internal controls is being
conducted under the direction of our senior management.  In addition,
our management is regularly discussing the results of our testing and any
proposed improvements to our control environment with our Audit
Committee.  We will continue to work to improve our controls and
procedures, and to educate and train our employees on our existing controls and
procedures in connection with our efforts to maintain an effective controls
infrastructure at our Company.





Limitations on Effectiveness
of Controls.  A system of controls, however well designed and
operated, can provide only reasonable, and not absolute, assurance that the
system will meet its objectives.  The design of a control system is
based, in part, upon the benefits of the control system relative to its
costs.  Control systems can be circumvented by the individual acts of
some persons, by collusion of two or more people, or by management override of
the control.  In addition, over time, controls may become inadequate
because of changes in conditions, or the degree of compliance with the policies
or procedures may deteriorate.  In addition, the design of any control
system is based in part upon assumptions about the likelihood of future
events.















42





PART
III





ITEM
      10.
            DIRECTORS,
      EXECUTIVE OFFICERS, AND CORPORATE
GOVERNANCE





The following table sets forth
certain information concerning the executive officers and directors of Fonix as
of March 31, 2008:





Name
            
            Age
            
            PositionRoger
      D.  Dudley
            
            55
            
            Director,
      Chief Executive Officer & Chief Financial
  Officer





All directors hold office until the
next annual meeting of the stockholders of Fonix or until their successors have
been elected and qualified.  Our officers are elected annually and
serve at the pleasure of the Board of Directors.





As noted elsewhere in this report,
Thomas A. Murdock served as President, Chief Executive Officer, and Chairman of
the Company during 2007 and through his resignation on March 5,
2007.





As noted elsewhere in this Report,
William A. Maasberg, Jr., served as a Director and Chief Operating Office of the
Company during 2007 and through his resignation as a Director on March 5, 2008,
and as Chief Operating Office on March 31, 2008.





ROGER
D.  DUDLEY is a co-founder of Fonix and has served as an executive
officer and member of our board of directors since June 1994.  Mr.
Dudley currently serves as the Company sole Director, chief executive officer
and chief financial officer.  After several years at IBM in marketing
and sales, he began his career in the investment banking industry.  He
has extensive experience in corporate finance, equity and debt private
placements and asset management.








Audit
Committee Financial Expert





The Board of Directors has determined
that we do not have an audit committee financial expert.  We have been
seeking to add an individual with these qualifications to our Board of Directors
but have been unable to find a suitable individual.  We continue to
search for someone who meets the qualifications of an audit committee financial
expert.


Compliance
With Section 16(a) of the Exchange Act





Section 16(a) of the Securities
Exchange Act of 1934 requires our officers and directors, and persons who
beneficially own more than 10% of a registered class of our equity securities,
to file reports of ownership and changes in ownership with the Securities and
Exchange Commission.  Officers, directors and greater than 10%
shareholders are required by regulation of the Securities and Exchange
Commission to furnish us with copies of all Section 16(a) forms which they
file.  Based solely on its review of the copies of such forms
furnished to us during the fiscal year ended December 31, 2007, we are aware of
the following untimely filings:





Messrs. Murdock and Dudley filed late
Forms 5.





Code
of Ethics Disclosure





In March 2004, our Board of Directors
adopted a Code of Ethics, or the Code, that applies to its and our executive
officers, including, among others, our chief executive officers and senior
financial officers, as well as all of our employees at all levels, including our
subsidiaries.  The Code is designed to deter wrongdoing and to matters
of business ethics including, but not limited to:








43





•
            Business
      Ethics - The Code states that it is the policy of the Company that each
      employee should conduct his or her affairs with uncompromising honesty and
      integrity.





•
            Public
      Reports - The Code notes that Fonix is a public reporting company, and
      expresses the policy that any employee who has a responsibility for
      assisting in preparation of public reports or other public filings must
      assure that the information contained in the report or filing is complete,
      accurate, and true in every
respect.





•
            Conflicts
      of Interest - The Code discusses possible situations of conflicts of
      interest, and requires that potential conflicts of interest be cleared
      through the Company's Audit
Committee.





•
            The
      Code prohibits gifts, bribes, or kickbacks being given or received by
      Fonix employees.  Additionally, the Code prohibits: loans to
      officers or directors; improper use or theft of Company property;
      falsifying records; abuse of Company, customer, associate, or vendor
      information; gathering information regarding competitors of the Company;
      defamation or misstatements; and improper use of Company or third-party
      software.





A copy of
our Code of Ethics was an exhibit to the annual report filed for
2003.  Additionally, we undertake to provide to any person without
charge, upon request, a copy of our Code of Ethics.  Such request may
be made in writing to the Board of Directors at our address listed on the first
page of this report.








ITEM
      11.
            EXECUTIVE
      COMPENSATION





Compensation
Discussion and Analysis





The following is a discussion of the
Company’s program for compensation of its named executive officers and
directors.  During 2007, the compensation committee of the Board of
Directors was responsible for determining the Company’s compensation
program.  On March 5, 2008 Messrs. Murdock and Maasberg resigned as
directors of the Company, and as such, Mr. Dudley, as the sole director as of
the date of this Report was responsible for the Company’s compensation
program.





Compensation
Program Objectives





The
Company’s compensation program is designed to encompass several factors in
determining the compensation of the Company’s named executive
officers.  The following are the main objectives of the compensation
program for the Company’s named executive officers:





-
            Retain
      qualified officers.


-
            Provide
      overall corporate direction for the officers and also to provide direction
      that is specific to officer’s respective areas of
      authority.  The level of compensation amongst the officer group,
      in relation to one another, is also considered in order to maintain a high
      level of satisfaction within the leadership group. We consider the
      relationship that the officers maintain to be one of the most important
      elements of the leadership group.


-
            Provide
      a performance incentive for the
officers.





The
Company’s compensation program is designed to reward the officers in the
following areas:





-
            achievement
      of specific goals;


-
            professional
      education and development;


-
            creativity
      in the form of innovative ideas and analysis for new programs and
      projects;


-
            new
      program implementation;


-
            attainment
      of company goals, budgets, and
objectives;


-
            results
      oriented determination and
organization;


-
            positive
      and supportive direction for company personnel;
  and


-
            community
      involvement.








44





As of the
date of this Report, there were three principal elements of named executive
officer compensation.  The Compensation Committee determines the
portion of compensation allocated to each element for each individual named
executive officer.  The discussions of compensation practices and
policies are of historical practices and policies.  Our Compensation
Committee is expected to continue these policies and practices, but will
reevaluate the practices and policies as it considers advisable.





The elements of the compensation
program include:





-
            Base
      salary;


-
            Stock
      options and stock awards;


-
            Employee
      benefits in the form of:


-
            health
      and dental insurance;


-
            auto
      reimbursement


-
            Other
      de minimis benefits.





Base
salary





Base
salary is intended to provide competitive compensation for job performance and
to attract and retain qualified named executive officers.  The base
salary level is determined by considering several factors inherent in the market
place such as: the size of the company; the prevailing salary levels for the
particular office or position; prevailing salary levels in a given geographic
locale; and the qualifications and experience of the named executive
officer.





Stock
options and stock awards





Stock
ownership is provided to enable named executive officers and directors to
participate in the success of the Company.  The direct or potential
ownership of stock will also provide the incentive to expand the involvement of
the named executive officer to include, and therefore be mindful of, the
perspective of stockholders of the Company.





Employee
benefits





Several
of the employee benefits for the named executive officers are selected to
provide security for the named executive officers.  Most notably,
health insurance coverage is intended to provide a level of protection to that
will enable the named executive officers to function without having the
distraction of having to manage undue risk.  The health insurance also
provides access to preventative medical care which will help the named executive
officers function at a high energy level, to manage job related stress, and
contribute to the overall well being of the named executive officers, all of
which contribute to an enhanced job performance.





Other de minimis benefits





Other de
minimis employee benefits such as cell phones and auto usage reimbursements are
directly related to job functions but contain a personal use element which is
considered to be a goodwill gesture that contributes to enhanced job
performance.





As
discussed above, the Compensation Committee determines the portion of
compensation allocated to each element for each individual named executive
officer.  As a general rule, base salary is competitively based while
giving consideration to employee retention, qualifications, performance, and
general market conditions.  Typically, stock options are based on the
current market value of the option and how that will contribute to the overall
compensation of the named executive officer.  Consideration is also
given to the fact that the option has the potential for an appreciated future
value.  As such this future value may in fact be the most significant
factor of the option, but it is also more difficult to quantify as a benefit to
the named executive officer.





Accordingly,
in determining the compensation program for the Company, as well as setting the
compensation for each named executive officer, the Compensation Committee of the
Board of Directors attempts to attract the interest of the named executive
officer within in the constraints of a compensation package that is fair and
equitable to all parties involved.





45





EXECUTIVE
COMPENSATION





SUMMARY COMPENSATION
TABLE


Name
      and Principal Position
            Year
            
            Salary
              ($)
            
            
            Bonus
              ($)
            
            
            Stock
      Awards
              ($)
            
            
            Option
      Grants
              ($)
            
            
            Non-Equity
      Incentive Plan Compensation
              ($)
            
            
            Change
      in Pension Value and Nonqualified Deferred Compensation
      Earnings
              ($)
            
            
            All
      Other Compensation
            
            
            Total
              ($)Thomas
      A. Murdock
              Chief Executive Officer &
      President(2)
            2007
            
            $
            309,400
            (1)
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            $
            10,210
            (4)
            
            $
            319,610Roger
      D. Dudley
              Executive
      vice President & Chief Financial Officer (2)
            2007
            
            $
            309,400
            (1)
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            $
            5,283
            (4)
            
            $
            314,683William
      A. Maasberg, Jr.
              Chief
      Operating Officer (5)
            2007
            
            $
            61,129
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            $
            61,129








(1)
            Due
      to cash flow difficulties, Messrs. Murdock and Dudley were not paid their
      full contracted rate of $309,400 for 2006, but were paid $97,465 and
      $107,198 respectively.





(2)
            We
      have an executive employment agreement Mr.Dudley.  The
      expiration date is December 31, 2010.  The material terms of the
      executive employment agreement with Mr. Dudley are as follows: the annual
      base salary is $309,400 and may be adjusted upward in future years as
      deemed appropriate by the board of
directors.





Mr.
Dudley also is entitled to customary insurance benefits, office and support
staff and an automobile allowance.  In addition, if Mr. Dudley is
terminated without cause during the contract term, then all salary then and
thereafter due and owing under the executive employment agreement shall, at the
executive’s option, be immediately paid in a lump sum payment to the executive
officer, and all stock options, warrants and other similar rights granted by us
and then vested or earned shall be immediately granted to the executive officer
without restriction or limitation of any kind.





The
executive employment agreement contains a non-disclosure, confidentiality,
non-solicitation and non-competition clause.  Under the terms of the
non-competition clause, Mr. Dudley has agreed that for a period of one year
after termination of his employment


with us
the executive will not engage in any capacity in a business which competes with
or may compete with Fonix.





During
2007, the Company had an executive employment agreement with Mr. Murdock on
terms that were identical to those in Mr. Dudley’s employment
agreement.  However, as noted above, Mr. Murdock resigned form the
Company on March 5, 2008.





(3)
            As
      noted above, on March 5, 2008 Mr. Murdock resigned as the Company’s
      President and Chief Executive
Officer.








(4)
            These
      amounts relate to expenses paid by the Company for the use of automobiles
      for the named executive officers.





(5)
            As
      noted above, Mr. Maasberg resigned as a director on March 5, 2008, and as
      Chief Operating Officer on March 31,
2008






































46





GRANTS
OF PLAN-BASED AWARDS


For
Fiscal Year Ended December 31, 2007





Name
            Grant
      Date
            Estimated
      Future Payouts Under Non-Equity Incentive Plan Awards
            Estimated
      Future Payouts Under Equity Incentive Plan Awards
            All
      Other Stock Awards: Number of Shares of Stock or Units
              (#)
            All
      Other Option Awards: Number of Securities Underlying Options
              (#)
            Exercise
      Price or Base Price of Option Awards
              ($/Sh)Threshold
              ($)
            Target
              ($)
            Maximum
              ($)
            Threshold
              (#)
            Target
              (#)
            Maximum
              (#)Thomas
      A. Murdock
            N/A
            --
            --
            --
            --
            --
            --
            --
            --
            --Roger
      D. Dudley
            N/A
            --
            --
            --
            --
            --
            --
            --
            --
            --William
      A. Maasberg, Jr.
            N/A
            --
            --
            --
            --
            --
            --
            --
            --
            --





For the
year ended December 31, 2007, there were no grants of plan based
awards.








OUTSTANDING
EQUITY AWARDS AT FISCAL 2007 YEAR-END





Option
      Awards
            Stock
      AwardsName
            Number
      of Securities Underlying Unexercised Options (#) Exercisable
            Number
      of Securities Underlying Unexercised Options
              (#)
              Unexercisable
            Equity
      Incentive Plan Awards: Number of Securities Underlying Unexercised
      Unearned Options
              (#)
            Option
      Exercise Price ($)
            Option
      Expiration Date
            Number
      of Shares or Units of Stock That Have Not Vested (#)
            Market
      Value of Shares or Units of Stock That Have Not Vested ($)
            Equity
      Incentive Plan Awards: Number of Unearned Shares, Units, or Other Rights
      That Have Not Vested
              (#)
            Equity
      Incentive Plan Awards: Market or Payout Value of Unearned Shares, Units,
      or Other Rights That Have Not Vested
              ($)Thomas
      A. Murdock
            101,250
            --
            --
            $0.04
            2010
            --
            $19
            --
            --Roger
      D. Dudley
            101,250
            --
            --
            $0.04
            2010
            --
            $19
            --
            --William
      A. Maasberg, Jr.
            27,500
            --
            --
            $0.04
            2010
            --
            $5
            --
            --








47





This
table lists the securities underlying unexercised options as of December 31,
2007, and related information.





OPTION
EXERCISES AND STOCK VESTED


For
Fiscal Year Ended December 31, 2007





Option
      Awards
            Stock
      AwardsName
      of Executive Officer
            Number
      of Shares Acquired on Exercise
              (#)
            Value
      Realized on Exercise
              ($)
            Number
      of Shares Acquired on Vesting
              (#)
            Value
      Realized on Vesting
              ($)Thomas
      A.. Murdock
            --
            --
            --
            --Roger
      D. Dudley
            --
            --
            --
            --William
      A. Maasberg, Jr.
            --
            --
            --
            --





For the
year ended December 31, 2007, there were no option exercises.





PENSION
BENEFITS


For
Fiscal Year Ended December 31, 2007





Name
            Plan
      Name
            Number
      of Years Credited Service
              (#)
            Present
      Value of Accumulated Benefit ($)
            Payments
      During Last Fiscal Year
              ($)Thomas
      A. Murdock
            N/A
            --
            --
            --Roger
      D. Dudley
            N/A
            --
            --
            --William
      A. Maasberg, Jr.
            N/A
            --
            --
            --





For the
year ended December 31, 2007, there were no pension benefits paid.  We
do not currently have a pension plan.








NONQUALIFIED
DEFERRED COMPENSATION


For
Fiscal Year Ended December 31, 2007





Name
            Executive
      Contributions
              in
      Last FY
              ($)
            Registrant
      Contributions
              in
      Last FY
              ($)
            Aggregate
      Earnings
              in
      Last FY
              ($)
            Aggregate
      Withdrawals/
              Distributions
              ($)
            Aggregate
      Balance
              at
      Last FYE
              ($)Thomas
      A. Murdock
            --
            --
            --
            --
            --Roger
      D. Dudley
            --
            --
            --
            --
            --William
      A. Maasberg, Jr.
            --
            --
            --
            --
            --





For the
year ended December 31, 2007, there was no non-qualified
compensation.








DIRECTOR
COMPENSATION


For
Fiscal Year Ended December 31, 2007





Name
            Fees
      Earned or Paid in Cash
              ($)
            Stock
      Awards
              ($)
            Option
      Awards
              ($)
            Non-Equity
      Incentive Plan Compensation
              ($)
            Change
      in Pension Value and Nonqualified Deferred Compensation
      Earnings
              ($)
            All
      Other Compensation
              ($)
            Total
              ($)Thomas
      A. Murdock
            --
            --
            --
            --
            --
            --
            --Roger
      D. Dudley
            --
            --
            --
            --
            --
            --
            --William
      A. Maasberg, Jr.
            --
            --
            --
            --
            --
            --
            --





For the
year ended December 31, 2007, no compensation was paid to the directors for
their service as directors.











48





Board
of Directors Meetings, Committees and Director Compensation





Our board of directors took action at
3 duly noticed meetings of the board during 2007.  Each director
attended (in person or telephonically) all of the meetings of Fonix’s board of
directors.  During 2007, our board of directors had the following
committees: Audit Committee, comprised of Messrs.  Dudley (chairman)
and Maasberg; and Compensation Committee, comprised of
Messrs.  Murdock (chairman) and Maasberg.  These standing
committees conducted meetings in conjunction with meetings of the full board of
directors.





On March 5, 2008, Messrs. Murdock and
Maasberg resigned as directors of the Company.  Because Mr. Dudley is
the sole remaining director, as of the date of this Report the Company had no
board committees.






Compensation
of Directors





Prior to April 1996, our directors
received no compensation for their service.  We historically have
reimbursed our directors for actual expenses incurred in traveling to and
participating in directors’ meetings, and we intend to continue that policy for
the foreseeable future.  On March 30, 1996, our board of directors
adopted, and our shareholders subsequently approved, our 1996 Directors’ Stock
Option Plan (the “Directors’ Plan”).  Under the Directors’ Plan,
members of the Board as constituted on the date of adoption received options to
purchase 5,000 shares of our Class A common stock for each year (or any portion
thereof consisting of at least six months) during which such persons had served
on the board for each of fiscal years 1994 and 1995 and were granted 5,000
shares for each of fiscal years 1996 through 2002, which options vested after
completion of at least six months’ service on the board during those fiscal
years.  These options have terms of ten years.  No options
were granted to our directors under the Directors’ Plan during
2006.  Similar grants have been made to our under our 1998 Stock
Option Plan, as set forth elsewhere in this report.





Stock
Performance Graph





The following graph compares the
yearly cumulative total returns from the Company’s Class A common stock during
the five fiscal year period ended December 31, 2006, with the cumulative total
return on the Media General Index and the Standard Industrial Classification
(SIC) Code Index for the same period.  The comparison assumes $100 was
invested on December 31, 2001, in the Company’s Class A common stock and in the
common stock of the companies in the referenced Indexes and further assumes
reinvestment of dividends.











2002
            2003
            2004
            2005
            2006
            2007FONIX
      CORPORATION
            100.00
            27.81
            12.06
            1.23
            0.18
            0.01NASDAQ
      MARKET INDEX
            100.00
            150.36
            163.00
            166.58
            183.68
            201.91SIC
      CODE INDEX - 7373
            100.00
            177.58
            222.58
            223.04
            202.33
            186.83














49





ITEM 12.
            SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS





The following table sets forth, as of
March  31, 2008, the number of shares of Common Stock of Fonix
beneficially owned by all persons known to be holders of more than five percent
of our Common Stock and by the executive officers and directors of Fonix
individually and as a group.    Unless indicated otherwise,
the address of the stockholder is our principal executive offices, 9350 South
150 East, Suite 700, Sandy, Utah 84070.





Name
      and Address of 5% Beneficial Owners, Executive Officers, and
      Directors
            Number
      of Shares
              Beneficially
      Owned
            Percent
      of Class (1)Roger
      D.  Dudley
              Chairman
      of the Board, Chief Executive Officer, Chief Financial Officer,
      Director
            3,577,419,398(3)
            38.34%Thomas
      A.  Murdock (2)
              Former
      Chairman of the Board & Former Chief Executive Officer
            1,123,379,815(4)
            13.34%Officer
      and Director as a Group
              (1
      person)
            3,577,419,398
            38.34%


(1)           Percentages
rounded to nearest 1/100th of one percent.  Except as indicated in the
footnotes below, each of the persons listed exercises sole voting and investment
power over the shares of Common Stock listed for each such person in the
table.





(2)           On
March 5, 2008, Mr. Murdock resigned as the Company’s Chairman, President, and
Chief Executive Officer.





(3)           Includes
40,000 shares of Common Stock deposited in a voting trust (the “Voting Trust”)
as to which Mr. Dudley is the sole trustee and 3,641,923,077 shares of Common
Stock issuable as of March 31, 2008, into the Voting Trust under a convertible
promissory note (the “Convertible Note”) held by Mr. Murdock and Mr.
Dudley.  Persons who have deposited their shares of Common Stock into
the Voting Trust have dividend and liquidation rights (“Economic Rights”) in
proportion to the number of shares of Common Stock they have deposited in the
Voting Trust, but have no voting rights with respect to such
shares.  All voting rights associated with the shares deposited into
the Voting Trust are exercisable solely and exclusively by the Trustee of the
Voting Trust.  The voting trust expires, unless extended according to
its terms, upon the earlier to occur of (i)(a) the sale of all of the shares of
common stock of the Company issued and issuable to the Shareholders upon
conversion of the entire unpaid of the Note in accordance with the terms and
conditions of the Note and the LOC Agreement; and (b) sale or distribution of
the Shares Certificates to the Shareholders; or (ii)(a)the payment in full of
the Note in accordance with the terms and conditions of the Note and the LOC
Agreement; and (b) sale or distribution of the Shares Certificates to the
Shareholders.  Although as the sole trustee of the Voting Trust Mr.
Dudley exercises the voting rights of all of the shares deposited into the
Voting Trust, and accordingly has listed all shares in the table above, he has
no economic or pecuniary interest in any of the shares deposited into the Voting
Trust except for 2,453,958,333 shares issuable as of March 31, 2008, under the
Convertible Note as to which he will directly own Economic Rights when
issued.  Also, (iv) includes 71 shares owned directly by Mr. Dudley,
(v) options to purchase 101,250 shares of the Company’s Common Stock, and (vi)
20,000 shares held in the Voting Trust.





(4)           Includes
(i) 1,123,339,744 common Stock issuable as of March 31, 2008, under the
Convertible Note which will be deposited into the Voting Trust when issued, (ii)
71 shares owned directly by Mr. Murdock, and (iii) 40,000 shares held in the
Voting Trust.




Plan
      Category
            Number
      of securities to be issued upon exercise of outstanding options, warrants,
      and rights
            Weighted
      average exercise price of outstanding options, warrants, and
      rights
            Number
      of securities remaining available for future issuance under equity
      compensation plansEquity
      compensation plans approved by shareholders
            376,500
            $0.11
            19,437,358Equity
      compensation plans not approved by shareholders
            --
            --
            --Total
            376,500
            $0.11
            19,437,358





ITEM
      13.
            CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
      INDEPENDENCE





Loans
from Senior Management to Company





During
2002, two of our executive officers (the “Lenders”) sold shares of our Class A
common stock owned by them and advanced the resulting proceeds amounting to
$333,000 to us under the terms of a revolving line of credit and related
promissory note.  The funds were advanced for use in our
operations.  The advances bear interest at 12 percent per annum, which
interest is payable on a semi-annual basis.  The entire principal,
along with unpaid accrued interest and any other unpaid charges or related fees,
was originally due and payable on June 10, 2003.  Fonix and the
Lenders have agreed to postpone the maturity date on several
occasions.  The note was due September 30, 2006.  As of
March 19, 2008, we had not made payment against the outstanding balance due on
the note. All or part of the outstanding balance and unpaid interest may be
converted at the option of the Lenders into shares of Class A common stock of
Fonix at any time.  The conversion price was the average closing bid
price of the shares at the time of the advances.  To the extent the
market price of our shares is below the conversion price at the time of
conversion, the Lenders are entitled to receive additional shares equal to the
gross dollar value received from the original sale of the shares.  The
Lenders may also receive additional compensation as determined appropriate by
the Board of Directors.








50





In October 2002, the Lenders pledged
30,866 shares of the Company's Class A common stock to the Equity Line Investor
in connection with an advance of $183,000 to us under the Third Equity
Line.  The Equity Line Investor subsequently sold the pledged shares
and applied $82,000 of the proceeds as a reduction of the
advance.  The value of the pledged shares of $82,000 was treated as an
additional advance from the Lenders.





During the fourth quarter of 2003, we
made a principal payment of $26,000 against the outstanding balance of the
promissory note.  During 2004, we entered into an agreement with the
holders of the promissory note to increase the balance of the note payable by
$300,000 in exchange for a release of the $1,443,000 of accrued liabilities
related to prior indemnity agreements between us and the note
holders.  We classified the release of $1,143,000 as a capital
contribution in the Consolidated Financial Statements during the fourth quarter
of 2004.  We made principal payments against the note of $253,000
during the year ended December 31, 2004.  During the year ended
December 31, 2005, we received an additional advance of $50,000 under the note
from the Lenders.  The balance due the Lenders at December 31, 2005
was $486,000.  For the year ended December 31, 2006 we received
additional advances and other consideration from the Lenders in the aggregate
amount of $419,000 and made principal payments to the Lenders against the note
of $105,000.  During the year ended December 31, 2007, the Company
received additional advances of $102,000.  The balance due at December
31, 2007, was $902,000.





The aggregate advances of $902,000 are
secured by the Company’s intellectual property rights and stock of Fonix
Speech.  As of December 31, 2007, the Lenders had not converted any of
the outstanding balance or interest into common stock.  However, on
March 24, 2008, the Lenders converted $10,000 into 53,913,701shares of our
common stock for the benefit of one of the Lenders, Thomas A.
Murdock.





As of
December 31, 2007, none of our directors were “independent directors” as each
was employed by the Company as an executive officer, as discussed
above.





ITEM
      14.
            PRINCIPAL
      ACCOUNTANT FEES AND SERVICES





(1) AUDIT
FEES





The aggregate fees billed for the
fiscal years ended December 31, 2007 and 2006, for professional services
rendered by Hansen Barnett & Maxwell P.C., for the audit of the registrant's
annual financial statements and review of the financial statements included in
the registrant's Form 10-Q or services that are normally provided by the
accountant in connection with statutory and regulatory filings or engagements
for fiscal year 2007 and 2006 were $59,000 and $97,000,
respectively.








(2)
AUDIT-RELATED FEES





The aggregate fees billed for the
fiscal year ended December 31, 2007 and 2006 for assurance and related services
by Hansen Barnett & Maxwell P.C., that are reasonably related to the
performance of the audit or review of the registrant's financial statements for
fiscal year 2007 and 2006 were $0 and $19,000, respectively.





(3)
TAX FEES





The aggregate fees billed for each of
the fiscal years ended December 31, 2007 and 2006, for professional services
rendered by Hansen Barnett & Maxwell P.C. for tax compliance, tax advice,
and tax planning, for those fiscal years were $1,000 and $1,000,
respectively.  Services provided included preparation of federal and
state income tax returns.





(4) ALL
OTHER FEES





The aggregate fees billed in each of
the fiscal years ended December 31, 2007 and 2006, for products and services
provided by Hansen Barnett & Maxwell P.C. other than those services reported
above, for those fiscal years were $10,000 and $0.  The other fees
billed in 2007 related to Hansen Barnett & Maxwell’s participation in an
audit of the Company’s 401K plan.  This participation was approved by
the Board of Directors prior to commencement.  Hansen Barnett &
Maxwell made no management decisions.





(5) AUDIT
COMMITTEE POLICIES AND PROCEDURES





Not applicable.





(6) If
greater than 50 percent, disclose the percentage of hours expended on the
principal accountant's engagement to audit the registrant's financial statements
for the most recent fiscal year that were attributed to work performed by
persons other than the principal accountant's full-time, permanent
employees.





Not applicable.








51




PART
IV





ITEM
      15.
            EXHIBITS
      AND FINANCIAL STATEMENT SCHEDULES





(A)
            Documents
      filed as part of this Form 10-K:1.
            Consolidated
      Financial Statements (included in Part II, Item 8)Consolidated
      Balance Sheets as of December 31, 2007 and 2006Consolidated
      Statements of Operations for the Years Ended December 31, 2007, 2006 and
      2005Consolidated
      Statements of Stockholders’ Deficit for the Years Ended December 31, 2007,
      2006 and 2005Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2007, 2006 and
      2005Notes
      to Consolidated Financial Statements2.
            Financial
      Statement Schedules: None3.
            Exhibits:
      The following Exhibits are filed with this Form 10-K pursuant to Item
      601(a) of Regulation S-K:Exhibit
      No.          
      Description of
      Exhibit9
            Amended
      and Restated Voting10.1
            Separation
      Agreement between Fonix Corporation and Thomas A.
  Murdock22
            Subsidiaries
      of Registrant31
            Certification
      of President and Chief Financial Officer32
            Certification
      of President and Chief Financial Officer Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.











52





SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.





Fonix
      CorporationDate:
      April 15, 2008
            By:
            /s/  Roger
      D.DudleyRoger
      D.  Dudley, President, Chief Executive
Officerand
      Chief Financial Officer(Principal  Executive
      Officer, Principal Financial andAccounting
      Officer)








In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated:











/s/  Roger
D.Dudley


Roger
D.  Dudley, Executive Vice President,


Chief Financial Officer, and
Director





April 15,
2008


Date



















53




FONIX
CORPORATION AND SUBSIDIARIES
 
 
 INDEX
TO FINANCIAL STATEMENTS
  Report
      of Independent Registered Public Accounting Firm
                F-2CONSOLIDATED
      FINANCIAL STATEMENTS:Consolidated
      Balance Sheets as of December 31, 2007 and 2006
                F-3Consolidated
      Statements of Operations and Comprehensive Loss for the Years Ended
      December 31, 2007, 2006 and 2005
                F-4Consolidated
      Statements of Stockholders’ Deficit for the Years Ended December 31, 2005,
      2006 and 2007
                F-5Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2007, 2006 and
      2005
                F-6Notes
      to Consolidated Financial Statements
                F-8
 
       
 HANSEN, BARNETT& MAXWELL,
      P.C.
                  A
      Professional Corporation
                  CERTIFIED
      PUBLIC ACCOUNTANTS
                  5
      Triad Center, Suite 750
                  Salt
      Lake City, UT 84180-1128
                  Phone:
      (801) 532-2200
                  Fax:
      (801) 532-7944
                  www.hbmcpas.com
                
                Registered
      with the Public Company
                  Accounting
      Oversight Board
                  
                  
                  logo
  
 REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 
 To the
Board of Directors and the Stockholders
 Fonix
Corporation
 
 We have
audited the accompanying consolidated balance sheets of Fonix Corporation and
subsidiaries as of December 31, 2007 and 2006, and the related consolidated
statements of operations and comprehensive loss, stockholders’ deficit, and cash
flows for each of the three years in the period ended December 31,
2007.  These consolidated financial statements are the responsibility
of the Company’s management.  Our responsibility is to express an
opinion on these financial statements based on our audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audits to obtain reasonable assurance about whether
the consolidated financial statements are free of material
misstatement.  The Company is not required to have, nor were we
engaged to perform, and audit of its internal control over financial
reporting.  Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company’s internal control over financial
reporting.  Accordingly, we express no such opinion.  An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the consolidated financial statements.  An audit also
includes assessing the accounting principles used and significant estimates made
by management, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis
for our opinion.
 
 In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Fonix Corporation and
subsidiaries as of December 31, 2007 and 2006, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2007, in conformity with accounting principles generally accepted
in the United States of America.
 
 The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern.  As discussed in Note 1
to the consolidated financial statements, the Company has incurred significant
operating losses and negative cash flows from operating activities during each
of the three years in the period ended December 31, 2007.  As of
December 31, 2007, the Company had an accumulated deficit of $277,943,000, and
negative working capital of $34,384,000.  These matters raise
substantial doubt about the Company’s ability to continue as a going
concern.  Management’s plans with respect to these matters are also
described in Note 1.  The accompanying consolidated financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.
 
 As
discussed in Note 1 of the consolidated financial statements, the Company
adopted Statement of  Financial Accounting Standards No. 123 (R),
Share-Based Payment, effective January 1, 2006.
 
 HANSEN,
      BARNETT & MAXWELL. P.C.Salt
      Lake City, UtahApril
      14, 2008
   F-2
  Fonix
Speech and Subsidiaries
 CONDENSED
CONSOLIDATED BALANCE SHEETS
  December
      31,
                  2007
                
                
                December
      31,
                  2006ASSETSCurrent
      assetsCash
      and cash equivalents
                
                $
                26,000
                
                
                $
                5,000Prepaid
      expenses and other current assets
                
                
                61,000
                
                
                
                4,000Total
      current assets
                
                
                87,000
                
                
                
                9,000Property and equipment,
      net of accumulated depreciation of $1,293,000 and $1,261,000,
      respectively
                
                
                16,000
                
                
                
                48,000Deposits
      and other assets
                
                
                108,000
                
                
                
                117,000Goodwill
                
                
                -
                
                
                
                2,631,000Total
      assets
                
                $
                211,000
                
                
                $
                2,805,000LIABILITIES
      AND STOCKHOLDERS' DEFICITCurrent
      liabilitiesAccrued
      liabilities
                
                $
                4,505,000
                
                
                $
                2,054,000Accounts
      payable
                
                
                1,532,000
                
                
                
                1,504,000Net
      liabilities of discontinued subsidiaries
                
                
                -
                
                
                
                20,819,000Derivative
      liability
                
                
                20,742,000
                
                
                
                20,941,000Accrued
      payroll and other compensation
                
                
                211,000
                
                
                
                214,000Accrued
      settlement obligation
                
                
                540,000
                
                
                
                1,530,000Deferred
      revenues
                
                
                445,000
                
                
                
                460,000Notes
      payable - related parties
                
                
                902,000
                
                
                
                800,000Series
      E debentures
                
                
                1,754,000
                
                
                
                1,754,000Current
      portion of notes payable
                
                
                3,833,000
                
                
                
                2,883,000Deposits
      and other
                
                
                7,000
                
                
                
                7,000Total
      current liabilities
                
                
                34,471,000
                
                
                
                52,966,000Long-term
      notes payable, net of current portion
                
                
                3,556,000
                
                
                
                2,988,000Total
      liabilities
                
                
                38,027,000
                
                
                
                55,954,000Commitments
      and contingenciesStockholders'
      deficitPreferred
      stock, $0.0001 par value;  50,000,000 shares
      authorized;Series
      A, convertible; 166,667 shares outstanding (aggregate liquidation
      preference of $6,055,000)
                
                
                500,000
                
                
                
                500,000Series
      L, convertible; 1,535 shares and 1,858 shares outstanding ,
      respectively
                
                
                -
                
                
                
                -Common
      stock, $0.0001 par value; 20,000,000,000 shares
authorized;Class
      A voting, 4,287,119,186 shares and 1,309,965,981 shares outstanding,
      respectively
                
                
                429,000
                
                
                
                131,000Class
      B non-voting, none outstanding
                
                
                -
                
                
                
                -Additional
      paid-in capital
                
                
                238,714,000
                
                
                
                236,936,000Outstanding
      warrants to purchase Class A common stock
                
                
                474,000
                
                
                
                474,000Cumulative
      foreign currency translation adjustment
                
                
                10,000
                
                
                
                10,000Accumulated
      deficit
                
                
                (277,943,000
                )
                
                
                (291,200,000
                )Total
      stockholders' deficit
                
                
                (37,816,000
                )
                
                
                (53,149,000
                )Total
      liabilities and stockholders' deficit
                
                $
                211,000
                
                
                $
                2,805,000
  See
accompanying notes to consolidated financial statements.
 F-3
 Fonix
      Corporation and SubsidiariesCONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONSAND
      COMPREHENSIVE LOSSYears
      Ended December 31,2007
              
              
              2006
              
              
              2005RevenuesSpeech
      licenses, royalties and maintenance
              
              $
              1,838,000
              
              
              $
              1,329,000
              
              
              $
              1,358,000Total
      Revenue
              
              
              1,838,000
              
              
              
              1,329,000
              
              
              
              1,358,000Cost
      of revenuesSpeech
      licenses, royalties and maintenance
              
              
              141,000
              
              
              
              18,000
              
              
              
              70,000Total
      cost of revenues
              
              
              141,000
              
              
              
              18,000
              
              
              
              70,000Gross
      profit
              
              
              1,697,000
              
              
              
              1,311,000
              
              
              
              1,288,000Operating
      expenses:Selling,
      general and administrative
              
              
              2,479,000
              
              
              
              5,356,000
              
              
              
              4,762,000Impairment
      of goodwill
              
              
              2,631,000
              
              
              
              -
              
              
              
              -Legal
      settlement expense
              
              
              -
              
              
              
              -
              
              
              
              2,080,000Product
      development and research
              
              
              1,572,000
              
              
              
              2,143,000
              
              
              
              2,196,000Total
      operating expenses
              
              
              6,682,000
              
              
              
              7,499,000
              
              
              
              9,038,000Other
      income (expense):Interest
      and other income
              
              
              -
              
              
              
              -
              
              
              
              8,000Interest
      expense
              
              
              (1,887,000
              )
              
              
              (1,737,000
              )
              
              
              (1,298,000
              )Gain
      (loss) on derivative liability
              
              
              813,000
              
              
              
              (2,771,000
              )
              
              
              -Gain
      on sale of investments
              
              
              -
              
              
              
              -
              
              
              
              104,000Gain
      on forgiveness of liabilities
              
              
              21,018,000
              
              
              
              -
              
              
              
              142,000Other
      income (expense), net
              
              
              19,944,000
              
              
              
              (4,508,000
              )
              
              
              (1,044,000
              )Income
      (loss) from continuing operations
              
              
              14,959,000
              
              
              
              (10,696,000
              )
              
              
              (8,794,000
              )Loss
      from discontinued operations
              
              
              -
              
              
              
              (11,247,000
              )
              
              
              (13,837,000
              )Net
      income (loss)
              
              
              14,959,000
              
              
              
              (21,943,000
              )
              
              
              (22,631,000
              )Preferred
      stock dividends
              
              
              (1,702,000
              )
              
              
              (18,735,000
              )
              
              
              (1,265,000
              )Income
      (loss) attributable to common stockholders
              
              $
              13,257,000
              
              
              $
              (40,678,000
              )
              
              $
              (23,896,000
              )Basic
      income (loss) per common share from continuing operations
              
              $
              0.01
              
              
              $
              (0.04
              )
              
              $
              (0.04
              )Basic
      and diluted income (loss) per common share from discontinued
      operations
              
              $
              -
              
              
              $
              (0.01
              )
              
              $
              (0.05
              )Diluted
      income per common share from continuing operations
              
              $
              0.00
              
              
              $
              -
              
              
              $
              -Net
      income (loss)
              
              $
              14,959,000
              
              
              $
              (21,943,000
              )
              
              $
              (22,631,000
              )Other
      comprehensive income - foreign currency translation
              
              
              -
              
              
              
              8,000
              
              
              
              10,000Comprehensive
      income (loss)
              
              $
              14,959,000
              
              
              $
              (21,935,000
              )
              
              $
              (22,621,000
              )
   See
accompanying notes to consolidated financial statements.
 
 F-4
 
 Fonix
      Corporation and SubsidiariesCONSOLIDATED
      STATEMENTS OF STOCKHOLDERS' DEFICITYEARS
      ENDED DECEMBER 31, 2005, 2006 AND 2007Outstanding
              
              
              CumulativeWarrants
              
              
              ForeignAdditional
              
              
              to
      Purchase
              
              
              CurrencyPreferred
      Stock
              
              
              Common
      Stock
              
              
              Paid-in
              
              
              Common
              
              
              Translation
              
              
              AccumulatedShares
              
              
              Amount
              
              
              Shares
              
              
              Amount
              
              
              Capital
              
              
              Stock
              
              
              Adjustment
              
              
              Deficit
              
              
              TotalBALANCE,
      DECEMBER 31,  2004
              
              
              170,917
              
              
              $
              6,750,000
              
              
              
              131,200,170
              
              
              $
              13,000
              
              
              $
              217,061,000
              
              
              $
              735,000
              
              
              $
              8,000
              
              
              $
              (226,625,000
              )
              
              $
              (2,058,000
              )Issuance
      of common stock under equity lines of credit
              
              
              -
              
              
              
              -
              
              
              
              180,480,405
              
              
              
              18,000
              
              
              
              7,809,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              7,827,000Shares
      issued for payment of principal and interest on long-term
    debt
              
              
              -
              
              
              
              -
              
              
              
              29,417,578
              
              
              
              3,000
              
              
              
              1,248,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              1,251,000Shares
      issued for payment of dividends on Series H Preferred
              
              
              -
              
              
              
              -
              
              
              
              27,275,299
              
              
              
              3,000
              
              
              
              1,123,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              1,126,000Conversion
      of Series I Preferred into common stock
              
              
              (1,078
              )
              
              
              (1,078,000
              )
              
              
              18,482,083
              
              
              
              2,000
              
              
              
              1,076,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Exchange
      of Series I Preferred for Series J Preferred
              
              
              280
              
              
              
              280,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              280,000Series
      J Preferred Stock beneficial conversion dividend
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              161,000
              
              
              
              -
              
              
              
              -
              
              
              
              (161,000
              )
              
              
              -Conversion
      of Series J Preferred into common stock
              
              
              (93
              )
              
              
              (93,000
              )
              
              
              3,795,918
              
              
              
              -
              
              
              
              93,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Shares
      issued in conection with legal settlement
              
              
              -
              
              
              
              -
              
              
              
              2,277,777
              
              
              
              -
              
              
              
              73,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              73,000Cumulative
      foreign currency translation adjustment
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              10,000
              
              
              
              -
              
              
              
              10,000Cancellation
      of warrants
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              261,000
              
              
              
              (261,000
              )
              
              
              -
              
              
              
              -
              
              
              
              -Dividend
      on Series H Preferred
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (1,000,000
              )
              
              
              (1,000,000
              )Dividend
      on Series I Preferred
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (86,000
              )
              
              
              (86,000
              )Dividend
      on Series J Preferred
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (18,000
              )
              
              
              (18,000
              )Net
      loss for year ended December 31, 2005
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (22,631,000
              )
              
              
              (22,631,000
              )BALANCE,
      DECEMBER 31, 2005
              
              
              170,026
              
              
              $
              5,859,000
              
              
              
              392,929,230
              
              
              $
              39,000
              
              
              $
              228,905,000
              
              
              $
              474,000
              
              
              $
              18,000
              
              
              $
              (250,521,000
              )
              
              $
              (15,226,000
              )Issuance
      of common stock under equity lines of credit
              
              
              -
              
              
              
              -
              
              
              
              300,000,000
              
              
              
              30,000
              
              
              
              3,250,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              3,280,000Shares
      issued for payment of dividends on Series H Preferred
              
              
              -
              
              
              
              -
              
              
              
              2,838,412
              
              
              
              -
              
              
              
              65,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              65,000Exchange
      of Series J Preferred for Series K Preferred
              
              
              
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Series
      J Preferred Stock beneficial conversion dividend
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              1,587,000
              
              
              
              -
              
              
              
              -
              
              
              
              (1,587,000
              )
              
              
              -Exchange
      of Series H Preferred for Series L Preferred
              
              
              
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Series
      L Preferred Stock beneficial conversion dividend
              
              
              -
              
              
              
              (4,000,000
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (16,000,000
              )
              
              
              (20,000,000
              )Conversion
      of Series J Preferred into common stock
              
              
              (266
              )
              
              
              (266,000
              )
              
              
              15,028,249
              
              
              
              2,000
              
              
              
              264,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Conversion
      of Series K Preferred into common stock
              
              
              (1,093
              )
              
              
              (1,093,000
              )
              
              
              109,300,000
              
              
              
              11,000
              
              
              
              1,082,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Conversion
      of Series L Preferred into common stock
              
              
              (142
              )
              
              
              -
              
              
              
              489,870,090
              
              
              
              49,000
              
              
              
              1,783,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              1,832,000Cumulative
      foreign currency translation adjustment
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (8,000
              )
              
              
              -
              
              
              
              (8,000
              )Dividend
      on Series H Preferred
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (693,000
              )
              
              
              (693,000
              )Dividend
      on Series J Preferred
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (5,000
              )
              
              
              (5,000
              )Dividend
      on Series K Preferred
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (11,000
              )
              
              
              (11,000
              )Dividend
      on Series L Preferred
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (440,000
              )
              
              
              (440,000
              )Net
      loss for year ended December 31, 2006
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (21,943,000
              )
              
              
              (21,943,000
              )BALANCE,
      DECEMBER 31, 2006
              
              
              168,525
              
              
              $
              500,000
              
              
              
              1,309,965,981
              
              
              $
              131,000
              
              
              $
              236,936,000
              
              
              $
              474,000
              
              
              $
              10,000
              
              
              $
              (291,200,000
              )
              
              $
              (53,149,000
              )Shares
      issued in conection with investor relations
              
              
              -
              
              
              
              -
              
              
              
              200,000,000
              
              
              
              20,000
              
              
              
              42,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              62,000Conversion
      of Series L Preferred into common stock
              
              
              (173
              )
              
              
              -
              
              
              
              2,777,153,205
              
              
              
              278,000
              
              
              
              1,736,000
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              2,014,000Dividend
      on Series L Preferred
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (1,481,000
              )
              
              
              (1,481,000
              )Dividend
      on Series M Preferred
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (102,000
              )
              
              
              (102,000
              )Dividend
      on Series N Preferred
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (34,000
              )
              
              
              (34,000
              )Dividend
      on Series B Preferred
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (85,000
              )
              
              
              (85,000
              )Net
      income for year ended December 31, 2007
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              14,959,000
              
              
              
              14,959,000BALANCE,
      DECEMBER 31, 2007
              
              
              168,352
              
              
              $
              500,000
              
              
              
              4,287,119,186
              
              
              $
              429,000
              
              
              $
              238,714,000
              
              
              $
              474,000
              
              
              $
              10,000
              
              
              $
              (277,943,000
              )
              
              $
              (37,816,000
              )








F-5
 
 Fonix
      Corporation and SubsidiariesCONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWSYears
      Ended December 31,2007
              
              
              2006
              
              
              2005Cash
      flows from operating activitiesNet
      income (loss)
              
              $
              14,959,000
              
              
              $
              (21,943,000
              )
              
              $
              (22,631,000
              )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Discontinued
      operations
              
              
              -
              
              
              
              11,644,000
              
              
              
              13,977,000Gain
      / (Loss) on derivative liability
              
              
              (813,000
              )
              
              
              2,772,000
              
              
              
              -Accretion
      of discount on notes payable
              
              
              1,068,000
              
              
              
              832,000
              
              
              
              741,000Non-cash
      expense related to the issuance of preferred stock
              
              
              -
              
              
              
              -
              
              
              
              250,000Stock
      issued for interest expense on long-term debt
              
              
              -
              
              
              
              -
              
              
              
              500,000Accretion
      of discount on legal settlement
              
              
              -
              
              
              
              117,000
              
              
              
              -Impairment
      of goodwill
              
              
              2,631,000
              
              
              
              -
              
              
              
              -Write
      down of intercompany receivable
              
              
              -
              
              
              
              1,214,000Legal
      settlement expense
              
              
              -
              
              
              
              -
              
              
              
              2,011,000Gain
      on sale of investment
              
              
              -
              
              
              
              -
              
              
              
              (104,000
              )Gain
      on forgiveness of liabilities
              
              
              (21,018,000
              )
              
              
              -
              
              
              
              (142,000
              )Depreciation
              
              
              32,000
              
              
              
              58,000
              
              
              
              59,000Foreign
      exchange loss (gain)
              
              
              -
              
              
              
              (8,000
              )
              
              
              10,000Changes
      in assets and liabilitiesAccounts
      receivable
              
              
              -
              
              
              
              1,000
              
              
              
              -Prepaid
      expenses and other current assets
              
              
              5,000
              
              
              
              135,000
              
              
              
              (65,000
              )Intercompany
      account
              
              
              -
              
              
              
              -
              
              
              
              (1,119,000
              )Other
      assets
              
              
              9,000
              
              
              
              (93,000
              )
              
              
              (33,000
              )Accounts
      payable
              
              
              28,000
              
              
              
              549,000
              
              
              
              (128,000
              )Accrued
      payroll and other compensation
              
              
              (3,000
              )
              
              
              (9,000
              )
              
              
              (1,433,000
              )Other
      accrued liabilities
              
              
              805,000
              
              
              
              689,000
              
              
              
              (544,000
              )Deferred
      revenues
              
              
              (15,000
              )
              
              
              (6,000
              )
              
              
              8,000Net
      cash used in operating activities
              
              
              (2,312,000
              )
              
              
              (4,048,000
              )
              
              
              (8,643,000
              )Cash
      flows from investing activitiesProceeds
      from sale of long term investments
              
              
              -
              
              
              
              -
              
              
              
              104,000Purchase
      of property and equipment
              
              
              -
              
              
              
              (12,000
              )
              
              
              (29,000
              )Net
      cash provided by (used in) investing activities
              
              
              -
              
              
              
              (12,000
              )
              
              
              75,000Cash
      flows from financing activitiesProceeds
      from issuance of Class A common stock, net
              
              
              -
              
              
              
              3,504,000
              
              
              
              7,827,000Proceeds
      from related party note payable
              
              
              102,000
              
              
              
              419,000
              
              
              
              50,000Proceeds
      from debentures
              
              
              -
              
              
              
              650,000
              
              
              
              650,000Proceeds
      from credit advance
              
              
              -
              
              
              
              75,000
              
              
              
              -Proceeds
      from issuance of Series N Preferred Stock
              
              
              1,350,000
              
              
              
              -
              
              
              
              -Proceeds
      from issuance of Series B Preferred Stock
              
              
              1,250,000
              
              
              
              -Proceeds
      from notes payable
              
              
              450,000
              
              
              
              330,000
              
              
              
              -Payments
      on related party note payable
              
              
              -
              
              
              
              (105,000
              )
              
              
              -Payments
      on accrued settlement obligation
              
              
              (819,000
              )
              
              
              (440,000
              )
              
              
              -Discontinued
      operations
              
              
              -
              
              
              
              (536,000
              )
              
              
              -Principal
      payments on notes payable
              
              
              -
              
              
              
              -
              
              
              
              (100,000
              )Net
      cash provided by financing activities
              
              
              2,333,000
              
              
              
              3,897,000
              
              
              
              8,427,000Net
      increase (decrease) in cash and cash equivalents
              
              
              21,000
              
              
              
              (163,000
              )
              
              
              (141,000
              )Cash
      and cash equivalents at beginning of year
              
              
              5,000
              
              
              
              168,000
              
              
              
              309,000Cash
      and cash equivalents at end of year
              
              $
              26,000
              
              
              $
              5,000
              
              
              $
              168,000









F-6
 Fonix
Corporation
 CONSOLIDATED
STATEMENTS OF CASH FLOWS (continued)
  Years Ended December 31,2007
                
                
                2006
                
                
                2005Supplemental
      Disclosure of Cash Flow InformationCash
      paid during the year for interest
                
                $
                29,000
                
                
                $
                22,000
                
                
                $
                310,000Cash
      paid during the year for income taxes
                
                
                –
                
                
                
                –
                
                
                
                –
 
 Supplemental
Schedule of Non-cash Investing and Financing Activities
 
 For
the Year Ended December 31, 2007
 
 Issued
2,777,153,205 shares of Class A common stock upon conversion of 173 shares of
Series L Convertible Preferred Stock.
  Accrued
$1,481,000 of dividends on Series L Preferred Stock.
  Accrued
$102,000 of dividends on Series M Preferred Stock.
  Accrued
$34,000 of dividends on Series N Preferred Stock.
  Accrued
$85,000 of dividends on Fonix Speech Series B Preferred Stock.
  Issued
150 shares of Series M Convertible Preferred Stock with a face value of
$1,500,000 in exchange for 150 shares of Series L Preferred Stock with a face
value of $1,500,000.
  Issued
1,349.85 shares of Series N Convertible Preferred Stock with a face value of
$1,349,850.
 
  For
the Year Ended December 31, 2006
 
 Issued
15,028,249 shares of Class A common stock in conversion of 266 shares of Series
J Convertible Preferred Stock.
  Issued
109,300,000 shares of Class A common stock in conversion of 1,093 shares of
Series K Convertible Preferred Stock.
  Issued
2,838,412 shares of Class A common stock as payment of $65,000 of dividends on
Series H Preferred Stock.
  Accrued
$692,000 of dividends on Series H Preferred Stock.
  Issued
2,000 shares of Series L Convertible Preferred Stock with a face value of
$20,000,000 in exchange for 2,000 shares of Series H Preferred Stock with a face
value of $20,000,000.
  Issued
489,870,090 shares of Class A common stock in conversion of 142 shares of Series
L Preferred Stock.
 
 For
the Year Ended December 31, 2005
 
 Issued
18,482,083 shares of Class A common stock in conversion of 1,078 shares of
Series I Convertible Preferred Stock.
  Issued
3,795,918 shares of Class A common stock in conversion of 93 shares of Series J
Convertible Preferred Stock.
  Issued
27,275,299 shares of Class A common stock as payment of $1,113,000 of dividends
on Series H Preferred Stock.
  Issued
29,417,578 shares of Class A common stock as payment of $1,248,000 of principal
and interest on long-term debt.
  Accrued
$137,000 of dividends on Series H Preferred Stock.
  Issued
1,452 shares of Series J Preferred Stock with a value of $1,452,000 in exchange
for 1,172 shares of Series I Preferred Stock with a value of $1,172,000, a
placement fee of $250,000 and settlement expense of $30,000.
  Issued
2,277,000 shares of Class A common stock for a legal settlement expense valued
at $73,000, or $0.03 per share.
    See
accompanying notes to consolidated financial statements.
 F-7
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 NOTE
1.  NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING
POLICIES
 
 Nature of
Operations -Fonix Corporation (“the Company”) provides value-added
speech technologies through its subsidiary, Fonix Speech, Inc. (“Fonix
Speech”).  The Company offers speech-enabling technologies including
automated speech recognition (“ASR”) and text-to-speech (“TTS”) through Fonix
Speech to markets for wireless and mobile devices, computer telephony, server
solutions and personal software for consumer applications.  The
Company has received various patents for certain elements of our core
technologies and have filed applications for other patents covering various
aspects of its technologies.  The Company seeks to develop
relationships and strategic alliances with third-party developers and vendors in
telecommunications, computers, electronic devices and related industries,
including producers of application software, operating systems, computers and
microprocessor chips.  Revenues are generated through licensing of
speech-enabling technologies, maintenance contracts and services.
 
 The
Company previously operated a telecommunications business, the results of which
were included in prior SEC filings.  On October 2, 2006, LecStar
Telecom Inc., a Georgia corporation (“LecStar Telecom”), LecStar DataNet, Inc.,
a Georgia corporation (“LecStar DataNet”), LTEL Holdings Corporation (“LTEL
Holdings”), a Delaware corporation, and Fonix Telecom Inc., a Delaware
corporation (“Fonix Telecom”), each of which are direct or indirect subsidiaries
of Fonix, filed for bankruptcy protection in the United States Bankruptcy Court
for the District of Delaware (the “Bankruptcy Court”).  The case
numbers are as follows:  LTEL Holdings Corporation, 06-11081 (BLS);
LecStar Telecom, Inc., 06-11082 (BLS); LecStar DataNet, Inc., 06-11083 (BLS);
Fonix Telecom, Inc., 06-11084 (BLS).)
 
 LecStar
Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom sought protection
under Chapter 7 of title 11 of the U.S. Bankruptcy Code, 11 U.S.C ss 101 et seq.
(the “Bankruptcy Code”).  Pursuant to Bankruptcy Code Section 701, on
October 3, 2006, Alfred Thomas Guliano was appointed the interim trustee for
LecStar Telecom, LecStar DataNet, LTEL Holdings, and Fonix
Telecom.  As these subsidiary companies were in Chapter 7 Bankruptcy
proceedings as of the date of this Report, the results of their operations have
been treated as discontinued operations.
 
 Business
Condition-For
the years ended December 31, 2007, 2006 and 2005, we generated revenues
of  $1,838,000, $1,329,000 and $1,358,000, respectively; net income of
$14,959,000, net losses $21,943,000 and $22,631,000, respectively, and had
negative cash flows from operating activities of $2,312,000, $4,048,000 and
$8,643,000, respectively.  As of December 31, 2007, we had an
accumulated deficit of $277,943,000, negative working capital of $34,384,000,
derivative liabilities of $20,742,000 related to the issuance of Series L
Preferred Stock,  Series M Preferred Stock, Series N Preferred
Stock,  Series E Convertible Debentures and Series B Preferred Stock
of our subsidiary, accrued liabilities and accrued settlement obligation of
$5,045,000, accounts payable of $1,532,000 and current portion of notes payable
of $3,833,000, Series E debentures of $1,754,000 and deferred revenues of
$445,000.We expect to continue to incur significant losses and negative cash
flows from operating activities at least through December 31, 2007, primarily
due to expenditure requirements associated with continued marketing and
development of our speech-enabling technologies.
 
 The
Company’s cash resources, limited to collections from customers, sales of our
equity and debt securities and loans, have not been sufficient to cover
operating expenses.  As a result, some payments to vendors have been
delayed.  On March 15, 2007, the New York State trial court entered
judgment against the Company and in favor of the Breckenridge Fund in the amount
of $1,602,000.  In February 2008, the Company entered into an amended
settlement agreement with Breckenridge under which the Company agreed to pay
Breckenridge $540,000.  The Company has paid Breckenridge $242,500 and
is obligated to pay the balance of $297,500 at the rate of $42,500 per
month.
 
 These
factors, as well as the risk factors set out elsewhere in the Annual Report on
Form 10-K,  raise substantial doubt about the Company’s ability to
continue as a going concern.  The accompanying financial statements do
not include any adjustments that might result from the outcome of this
uncertainty.  Management plans to fund further operations of the
Company from cash flows from future license and royalty arrangements and with
proceeds from additional issuance of debt and equity
securities.  There can be no assurance that management’s plans will be
successful.
 
  F-8
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 Consolidation-The accompanying
consolidated financial statements include the accounts of the Company and its
wholly owned subsidiaries.  All significant intercompany balances and
transactions have been eliminated in consolidation.
 
 The
Company has not consolidated the assets, liabilities or operations related to
the discontinued subsidiaries as these assets are under the control of the court
appointed bankruptcy trustee pursuant to the filing for protection under Chapter
7 of the Bankruptcy Code by LecStar Telecom, Inc., LecStar DataNet, Inc., LTEL
Holdings and Fonix Telecom, Inc., on October 2, 2006.  The
accompanying footnotes do not include disclosures related to the operations of
the aforementioned companies and represent solely the operations of Fonix
Speech, Inc.
 
 Accounting
Estimates-The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
the disclosures of contingent assets and liabilities at the date of the
financial statements, and the reported amounts of revenues and expenses during
the reporting period.  Actual results could differ from those
estimates.
 
 Fair Value of
Financial Instruments - The carrying values of the Company’s liabilities
approximate their fair values.  The estimated fair values have been
determined using appropriate market information and valuation
methodologies.  The carrying values of the accrued settlement
obligation and note payable approximate fair value because the stated or imputed
interest rates approximate the Company’s borrowing rate.
 
 Concentration of
Credit Risks-The Company’s cash and cash equivalents are maintained in bank deposit
accounts which occasionally may exceed federally insured limits.  Cash
equivalents consist of highly liquid securities with maturities of three months
or less when purchased.  The Company has not experienced any losses
with respect to these deposits.  In the normal course of business, the
Company provides credit terms to its customers.  Accordingly, the
Company performs on-going credit evaluations of its customers and maintains
allowances for possible losses, which when realized, have been within the range
of management’s expectations.
 
 Valuation of
Long-lived Assets - The carrying values of the Company's long-lived
assets are reviewed for impairment whenever events or changes in circumstances
indicate that they may not be recoverable.  When such an event occurs,
the Company projects undiscounted cash flows to be generated from the use of the
asset and its eventual disposition over the remaining life of the
asset.  If projections indicate that the carrying value of the
long-lived asset will not be recovered, the carrying value of the long-lived
asset, other than software technology, is reduced by the estimated excess of the
carrying value over the projected discounted cash flows.  The
determination of whether the carrying value of software technology is
recoverable is discussed below in the section titled “Software Technology
Development and Production Costs” within this note.
 
 Goodwill –
Goodwill represents the excess of the cost over the fair value of net assets of
acquired businesses. Goodwill is not amortized, but is tested for impairment
quarterly or when a triggering event occurs.  The testing for
impairment requires the determination of the fair value of the asset or entity
to which the goodwill relates (the reporting unit).  The fair value of
a reporting  unit is determined based upon a weighting of the quoted
market price of the Company’s common stock and present value techniques based
upon estimated future cash flows of the reporting unit, considering future
revenues, operating costs, the risk-adjusted discount rate and other
factors.  Impairment is indicated if the fair value of the reporting
unit is allocated to the assets and liabilities of that unit, with the excess of
the fair value of the reporting unit over the amounts assigned to its assets and
liabilities assigned to the fair value of goodwill.  The amount of
impairment of goodwill is measured by the excess of the goodwill’s carrying
value over its fair value.  As of December 31, 2006 and 2005, the fair
value of goodwill was greater than the carrying value.  At December
31, 2007, the Company determined that the carrying value of goodwill was in
excess of its fair value and the balance of $2,631,000 was fully
impaired.
 
 Revenue
Recognition – The Company recognizes revenue when pervasive evidence of
an arrangement exists; services have been rendered or products have been
delivered; the price to the buyer is fixed and determinable; and collectibility
is reasonably assured.  Revenues are recognized by the Company based
on the various types of transactions generating the revenue.  For
software sales, the Company recognizes revenues in accordance with the
provisions of Statement of Position No. 97-2, “Software Revenue Recognition,”
and related interpretations.The Company
generates revenues from licensing the rights to its software products to end
users and from royalties.  For telecommunications services, revenue is
recognized in the period that the service is provided.
 
  F-9
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 For Fonix
Speech, revenue of all types is recognized when acceptance of functionality,
rights of return, and price protection are confirmed or can be reasonably
estimated, as appropriate.  Revenues from development and consulting
services are recognized on a completed-contract basis when the services are
completed and accepted by the customer.  The completed-contract method
is used because the Company’s contracts are typically either short-term in
duration or the Company is unable to make reasonably dependable estimates of the
costs of the contracts.  Revenue for hardware units delivered is
recognized when delivery is verified and collection assured.
 
 Revenue
for products distributed through wholesale and retail channels and through
resellers is recognized upon verification of final sell-through to end users,
after consideration of rights of return and price
protection.  Typically, the right of return on such products has
expired when the end user purchases the product from the retail
outlet.  Once the end user opens the package, it is not returnable
unless the medium is defective.
 
 When
arrangements to license software products do not require significant production,
modification or customization of software, revenue from licenses and royalties
are recognized when persuasive evidence of a licensing arrangement exists,
delivery of the software has occurred, the fee is fixed or determinable, and
collectibility is probable.  Post-contract obligations, if any,
generally consist of one year of support including such services as customer
calls, bug fixes, and upgrades.  Related revenue is recognized over
the period covered by the agreement.  Revenues from maintenance and
support contracts are also recognized over the term of the related
contracts.
 
 Revenues
applicable to multiple-element fee arrangements are bifurcated among the
elements such as license agreements and support and upgrade obligations using
vendor-specific objective evidence of fair value.  Such evidence
consists primarily of pricing of multiple elements as if sold as separate
products or arrangements.  These elements vary based upon factors such
as the type of license, volume of units licensed, and other related
factors.
 
 Deferred
revenue as of December 31, 2007, consisted of the following:
 
 Description
                
                Criteria
      for Recognition
                
                
                AmountDeferred
      unit royalties and license fees
                
                Delivery
      of units to end users or expiration of contract
                
                
                $
                445,000
  Cost of Revenues
-Cost of revenues from license, royalties, and maintenance consists of
costs to distribute the product, installation and support personnel
compensation, amortization and impairment of capitalized speech software costs,
licensed technology, and other related costs.  Cost of service
revenues consists of personnel compensation and other related
costs.
 
 Software
Technology Development and Production Costs- All costs incurred to
establish the technological feasibility of speech software technology to be
sold, leased, or otherwise marketed are charged to product development and
research expense.  Technological feasibility is established when a
product design and a working model of the software product have been completed
and confirmed by testing.  Costs to produce or purchase software
technology incurred subsequent to establishing technological feasibility are
capitalized.  Capitalization of software costs ceases when the product
is available for general release to customers.  Costs to perform
consulting or development services are charged to cost of revenues in the period
in which the corresponding revenues are recognized.  Costs of
maintenance and customer support are charged to expense when related revenue is
recognized or when these costs are incurred, whichever occurs
first.
 
 Capitalized
software technology costs were amortized on a product-by-product
basis.  Amortization was recognized from the date the product was
available for general release to customers as the greater of (a) the ratio that
current gross revenue for a product bears to total current and anticipated
future gross revenues for that product or (b) the straight-line method over the
remaining estimated economic life of the products.  Amortization was
charged to cost of revenues.
 
  F-10
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 The
Company assessed unamortized capitalized software costs for possible write down
on a quarterly basis based on net realizable value of each related
product.  Net realizable value was determined based on the estimated
future gross revenues from a product reduced by the estimated future cost of
completing and disposing of the product, including the cost of performing
maintenance and customer support.  The amount by which the unamortized
capitalized costs of a software product exceeded the net realizable value of
that asset was written off.
 
 During
2003, the Company modified its estimate of future cash flows to be provided by
its software technology and determined that the carrying amount of the
technology was in excess of future cash flows provided by the
technology.  Accordingly, the Company recorded a charge of $1,124,000
during the year ended December 31, 2003, to fully impair the carrying value of
the speech software technology.  $822,000 of the impairment was
charged to cost of revenues and $302,000 was charged to operating expenses,
based on the use of the software.
 
 Stock-based
Compensation Plans - Effective January 1, 2006, the Company adopted
Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment”
(“SFAS 123(R)”), an amendment of SFAS No. 123, “Accounting for Stock-Based
Compensation” (“SFAS 123”) using the modified prospective transition
method.  Under this transition method, compensation costs are
recognized beginning with the effective date: (a) based on the requirements of
SFAS 123(R) for all share-based awards granted after the effective date; and (b)
based on the requirements of SFAS 123 for all awards granted to employees prior
to the effective date of SFAS 123(R) that remain unvested on the effective
date.  Accordingly, the Company did not restate the results of prior
periods.  The most notable change resulting from the adoption of
SFAS123(R) is that compensation expense associated with stock options is now
recognized in the Company’s Statements of Operations, rather than being
disclosed in a pro forma footnote to the Company’s financial
statements.
 
 Prior to
January 1, 2006, the Company accounted for stock options granted under its Stock
Option Plans under the recognition and measurement provisions of Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees) and related interpretations, as permitted by SFAS
123.  Had the Company determined compensation cost based on the fair
value at the grant date for its stock options under SFAS No. 123, the Company’s
net loss would have been increased to the pro forma amounts indicated below for
years ended December 31, 2005.
 
 Year
      Ended December 31,
                
                2005Net
      loss, as reported
                
                $
                (22,631,000
                )Add
      back: Total stock-based employee compensation
                
                
                -Deduct:
      Total stock-based employee compensation determined under fair value based
      method for all awards
                
                
                (74,000
                )Pro
      forma net loss
                
                $
                (22,705,000
                )Basic
      and diluted net loss per common share:As
      reported
                
                $
                (0.09
                )Pro
      forma
                
                
                (0.09
                )
  Advertising Costs- Advertising costs are expensed when incurred.  Total
advertising expense was $13,000, $40,000 and $80,000 for the years ended
December 31, 2007, 2006 and 2005, respectively.
 
 Income
Taxes-The
Company recognizes deferred income tax assets or liabilities for the expected
future tax consequences of events that have been recognized in the financial
statements or tax returns.  Deferred income tax assets or liabilities
are determined based upon the difference between the financial and income tax
bases of assets and liabilities using enacted tax rates expected to apply when
differences are expected to be settled or realized.
 
 Net Loss Per
Common Share-Basic and diluted net loss per common share are calculated by dividing
net loss attributable to common stockholders by the weighted-average number of
shares of common stock outstanding during the year.  At December 31,
2007, 2006 and 2005, there were outstanding common stock equivalents to purchase
or receive 98,211,685,667, 5,647,746,872 and 97,634,670 shares of common stock,
respectively. At December 31, 2007, 558,167 common stock equivalents were
excluded in the computation of diluted net income per common share as their
effect would have been anti-dilutive.  All common stock equivalents at
December 31, 2006 and 2005 were excluded in the computation of diluted net loss
per common share as their effect would have been anti-dilutive, thereby
decreasing the net loss per common share.
 
  F-11
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 The
following table is a reconciliation of the net income or loss numerator of basic
and diluted net income or loss per common share for the years ended December 31,
2007, 2006, and 2005:
 
 Years
      Ended December 31,2007
                
                
                2006
                
                
                2005Per
                
                
                
                
                
                Per
                
                
                
                
                
                PerShare
                
                
                
                
                
                Share
                
                
                
                
                
                ShareAmount
                
                
                
                Amount
                
                
                Amount
                
                
                Amount
                
                
                Amount
                
                
                AmountNet
      income (loss) from continuing operations
                
                $
                14,959,000
                
                
                
                
                
                
                $
                (10,696,000
                )
                
                
                
                
                $
                (8,794,000
                )Net
      loss from discontinued operations
                
                
                
                
                
                
                
                
                
                
                (11,247,000
                )
                
                $
                (0.01
                )
                
                
                (13,837,000
                )
                
                $
                (0.05
                )Net
      income (loss)
                
                
                14,959,000
                
                
                
                
                
                
                
                (21,943,000
                )
                
                
                
                
                
                
                (22,631,000
                )Preferred
      stock dividends
                
                
                (1,702,000
                )
                
                
                
                
                
                
                (18,735,000
                )
                
                
                
                
                
                
                (1,265,000
                )Net
      income (loss) attributable to common stockholders
                
                $
                13,257,000
                
                
                
                
                
                
                $
                (40,678,000
                )
                
                
                
                
                
                $
                (23,896,000
                )Basic
      weighted-average common shares outstanding
                
                
                2,417,708,937
                
                
                $
                0.01
                
                
                
                768,076,936
                
                
                $
                (0.05
                )
                
                
                261,894,849
                
                
                $
                (0.09
                )Diluted
      weighted-average common shares outstanding
                
                
                100,628,836,437
                
                
                $
                0.00
                
                
                
                768,076,936
                
                
                $
                (0.05
                )
                
                
                261,894,849
                
                
                $
                (0.09
                )
 
 Imputed Interest
Expense and Income-Interest is imputed on long-term debt obligations and notes receivable
where management has determined that the contractual interest rates are below
the market rate for instruments with similar risk characteristics (see Notes 2
and 6).
 
 Foreign Currency
Translation-The
functional currency of the Company’s Korean subsidiary is the South Korean
won.  Consequently, assets and liabilities of the Korean operations
are translated into United States dollars using current exchange rates at the
end of the year.  All revenue is invoiced in South Korean won and
revenues and expenses are translated into United States dollars using
weighted-average exchange rates for the year.
 
 Comprehensive
Income-Other
comprehensive income presented in the accompanying consolidated financial
statements consists of cumulative foreign currency translation
adjustments.
 
 Recently Enacted
Accounting Standards
 
 Business
Combinations -  In December 2007, the Financial Accounting
Standards Board (“FASB”) issued Statement of Financial Accounting Standards
(“SFAS”) No. 141 (revised 2007),“Business Combinations.”
This accounting principle requires the fundamental requirements of acquisition
accounting (purchase accounting) be applied to all business combinations in
which control is obtained regardless of consideration and for an acquirer to be
identified for each business combination. Additionally, this accounting
principle requires acquisition-related costs and restructuring costs at the date
of acquisition to be expensed rather than allocated to the assets acquired and
the liabilities assumed; minority interests, including goodwill, to be recorded
at fair value at the acquisition date; recognition of the fair value of assets
and liabilities arising from contractual contingencies and contingent
consideration (payments conditioned on the outcome of future events) at the
acquisition date; recognition of bargain purchase (acquisition-date fair value
exceeds consideration plus any noncontrolling interest) as a gain; and
recognition of changes in deferred taxes. This accounting principle will be
adopted January 2009. The accounting requirements will be adopted prospectively.
Earlier adoption is prohibited. Adoption is not expected to have an impact on
the Company’s consolidated financial position, results of operations or cash
flows.
 
  F-12
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 Noncontrolling
Interests in Consolidated Financial Statements - In December 2007, FASB
issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial
Statements.”  This accounting principle eliminates noncomparable
accounting for minority interests. Specifically, minority interests are
presented as a component of shareholders’ equity; consolidated net income
includes amounts attributable to both the parent and minority interest and is
disclosed on the face of the income statement; changes in the ownership interest
are accounted for as equity transactions if ownership remains controlling;
elimination of purchase accounting for acquisitions of noncontrolling interests
and acquisitions of additional interests; and recognition of deconsolidated
controlling interest based on fair value consistent with Statement of Financial
Accounting Standards No. 141 (revised 2007),Business Combinations. This
accounting principle will be adopted January 2009. The accounting requirements
will be adopted prospectively, however presentation and disclosure will be
adopted retrospectively for all periods presented. Earlier adoption is
prohibited. Adoption is not expected to have an impact on the Company’s
consolidated financial position, results of operations or cash
flows.
 
 Fair Value
Measurements-In September 2006, the FASB issued SFAS No. 157, “Fair Value
Measurements” (“SFAS 157”). SFAS 157 provides guidance for using fair value to
measure assets and liabilities. The standard also responds to investors’ request
for expanded information about the extent to which a company measures assets and
liabilities at fair value, the information used to measure fair value, and the
effect of fair value measurements on earnings. SFAS 157 will be effective for
the Company’s fiscal year beginning January 1, 2008.  In February 2008
the FASB Staff Position No. 157-2 which extended the effective date for certain
nonfinancial assets and nonfinancial liabilities to fiscal years beginning after
November 15, 2008.  The Company is currently reviewing the effect that
the adoption of SFAS 157 will have on its financial statements.
 
 NOTE
2.  PROPERTY AND EQUIPMENT
 
 Property
and equipment are stated at cost.  Depreciation is computed on a
straight-line basis over the estimated useful lives of the assets as
follows:
 
 Computer
      equipment and software
                
                3
      to 5 yearsFurniture
      and fixtures
                
                5
      years
  Maintenance
and repairs are charged to expense as incurred and major improvements are
capitalized.  Gains or losses on sales or retirements are included in
the consolidated statements of operations in the year of
disposition.  Depreciation expense was $32,000, $58,000 and $59,000
for the years ended December 31, 2007, 2006, and 2005,
respectively.  Property and equipment consisted of the following at
December 31, 2007 and 2006:
 
 2007
                
                
                2006Computer
      equipment
                
                $
                980,000
                
                
                $
                980,000Software
                
                
                201,000
                
                
                
                201,000Furniture
      and fixtures
                
                
                128,000
                
                
                
                128,0001,309,000
                
                
                
                1,309,000Less
      accumulated depreciation and amortization
                
                
                (1,293,000
                )
                
                
                (1,261,000
                )Net
      Property and Equipment
                
                $
                16,000
                
                
                $
                48,000
 
 NOTE
3.  GOODWILL AND INTANGIBLE ASSETS
 
 The
carrying value of goodwill is assessed for impairment quarterly.  The
Company tested goodwill for impairment at December 31, 2007 and determined that
goodwill had been fully impaired.  The Company recorded an impairment
charge of $2,631,000 in the accompanying financial statements.
 
  F-13
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 NOTE
4.  NOTES PAYABLE
 
 In
connection with the acquisition of the capital stock of LTEL Holdings in 2004,
the Company issued a 5%, $10,000,000, secured, six-year note (the “Note”)
payable to McCormack Avenue, Ltd. (“McCormack”).  Under the terms of
the Note, quarterly interest- only payments were required through January 15,
2005, with quarterly principal and interest payments of $319,000 beginning April
2005 and continuing through January 2010.  Interest on the Note is
payable in cash or, at the Company’s option, in shares of the Company’s Class A
common stock.  The Note is secured by the capital stock and all of the
assets of LTEL Holdings and its subsidiaries.  The Note was originally
valued at $4,624,000 based on an imputed interest rate of 25 percent per
annum.
 
 The
discount on the Note is based on an imputed interest rate of 25%.  The
carrying amount of the Note of $6,609,000 at December 31, 2007, was net of
unamortized discount of $2,124,000.  As of the date of this report,
the Company had not made any scheduled payments for 2006 or 2007.
 
 On September 8, 2006, the Company
received a default notice (the “Default Notice”) from McCormack relating to the
Note.  Under the terms of the Note, and a related Security Agreement
between the Company and McCormack dated February 24, 2004 (the “Security
Agreement”), McCormack may declare all liabilities, indebtedness, and
obligations of the Company to McCormack under the Security Agreement and the
Note immediately due and owing upon an event of default.  The Note
defines an event of default to include the non-payment by the Company of a
scheduled payment which is not cured within 60 days.
 
 In the
Default Notice, McCormack stated that it intended to exercise its rights,
including any and all rights set forth in the Note, as amended.
 
 Also on
September 8, 2006, McCormack provided to the Company a Notice of Sale, stating
McCormack’s intention to sell at public auction all of the collateral referred
to in the Security Agreement, consisting of the capital stock and assets of
LecStar Telecom, LecStar DataNet, and LTEL Holdings.  To date, no sale
of the assets or capital stock of LecStar Telecom, LecStar DataNet nor LTEL
Holdings has occurred.  On October 2, 2006, LecStar Telecom, LecStar
DataNet and LTEL Holdings filed for protection under Chapter 7 of the Bankruptcy
Code.  As of the date of this Report, the results of their operations
have been treated as discontinued operations.
 
 During
the fourth quarter of 2005, the Company entered into two promissory notes with
an unrelated third party in the aggregate amount of $650,000.  These
notes accrue interest at 10% annually and were due and payable during the second
quarter of 2006.  The notes, along with accrued interest of $64,000
and additional advances of $325,000 were exchanged for the McCormack Debenture
(described in Note 8).
 
 During
the fourth quarter of 2006, the Company entered into two promissory notes with
an unrelated third party in the aggregate amount of $330,000. These notes accrue
interest at 10% annually and were due and payable during the second quarter of
2007.  As of the date of this report, the Company had not made the
scheduled payments on these promissory notes, and the holder of the notes had
not declared a default under the notes.
 
 During
the quarter ended March 31, 2007, the Company entered into five promissory notes
with an unrelated third party in the aggregate amount of
$450,000.  These notes accrue interest at 10% annually and were due
and payable during the third quarter of 2007.  As of the date of this
report, the Company had not made the scheduled payments on these promissory
notes, and the holder of the notes had not declared a default under the
notes.
 
 The
following schedule summarizes the Company’s current debt obligations and
respective balances at December 31, 2007 and 2006:
 
  F-14
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 Notes Payable
                
                
                December 31, 2007
                
                
                December 31, 20065%
      Note payable to a company, $8,733,000 face amount, due in quarterly
      installments of $319,000, matures January 2010, less unamortized discount
      based on interest imputed at 25% of $2,124,000 and $3,191,000,
      respectively
                
                
                $
                6,609,000
                
                
                $
                5,541,000Note
      payable to a company, interest at 10%, matured June 2007
                
                
                
                235,000
                
                
                
                235,000Note
      payable to a company, interest at 10%, matured June 2007
                
                
                
                95,000
                
                
                
                95,000Note
      payable to a company, interest at 10%, matured July 2007
                
                
                
                450,000
                
                
                
                --Note
      payable to related parties, interest at 12%, matured September 2006,
      secured by intellectual property rights
                
                
                
                902,000
                
                
                
                800,000Total
      notes payable
                
                
                
                8,291,000
                
                
                
                6,671,000Less
      current maturities
                
                
                
                (4,735,000
                )
                
                
                (3,683,000
                )Long-Term
      Note Payable
                
                
                $
                3,556,000
                
                
                $
                2,988,000
 
 
 The
following table shows the schedule of principal payments under notes payable and
related party notes payable as of December 31, 2007:
  Year ending December
      31,
                
                Payments2008
                
                $
                5,280,0002009
                
                
                1,036,0002010
                
                
                4,098,000$
                10,414,000
 
 NOTE
5.  RELATED-PARTY NOTES PAYABLE
 
 During
2002, two executive officers of the Company (the “Lenders”) sold shares of the
Company’s Class A common stock owned by them and advanced the resulting proceeds
amounting to $333,000 to the Company under the terms of a revolving line of
credit and related promissory note.  The funds were advanced for use
in Company operations.  The advances bear interest at 12 percent per
annum, which interest is payable on a semi-annual basis.  The entire
principal, along with unpaid accrued interest and any other unpaid charges or
related fees, was originally due and payable on June 10, 2003.  The
Company and the Lenders have agreed to postpone the maturity date on several
occasions.  The note was due September 30, 2006.  As of
March 31, 2008, the Company had not made payment against the outstanding balance
due on the note.  All or part of the outstanding balance and unpaid
interest may be converted at the option of the Lenders into shares of Class A
common stock of the Company at any time.  The conversion price is the
average closing bid price of the shares at the time of the
advances.  To the extent the market price of the Company’s shares is
below the conversion price at the time of conversion, the Lenders are entitled
to receive additional shares equal to the gross dollar value received from the
original sale of the shares.  A beneficial conversion option of
$15,000 was recorded as interest expense in connection with this
transaction.  The Lenders may also receive additional compensation as
determined appropriate by the Board of Directors.
 
  F-15
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 During
the year ended December 31, 2005, the Company received an additional advance of
$50,000 against the promissory note.  The balance due at December 31,
2005 was $486,000.  During the year ended December 31, 2006, the
Company received additional advances and other consideration from the Lenders in
the aggregate amount of $419,000 and made principal payments to the Lenders
against the note of $105,000.  During the year ended December 31,
2007, the Company received additional advances of $102,000.  The
balance due at December 31, 2007, was $902,000.
 
 The
aggregate advances of $902,000 are secured by the Company’s intellectual
property rights and common stock of Fonix Speech.  As of December 31,
2007, the Lenders had not converted any of the outstanding balance or interest
into common stock.  However, on March 24, 2008, the Lenders converted
$10,000 into 53,913,701shares of our common stock for the benefit of one of the
Lenders, Thomas A. Murdock.
 
 NOTE
6.  DEBENTURES
 
 Series E
Debentures - On December 7, 2006, the Company entered into a Securities
Purchase Agreement, dated as of December 1, 2006 (the “Agreement”), with
Southridge Partners, LP (“Southridge”) relating to the purchase and sale of a
Series E 9% Secured Subordinated Convertible Debenture (the “Southridge
Debenture”) in the principal amount of $850,000.
 
 Pursuant
to the Agreement, Southridge paid the purchase price by tendering a prior
debenture in the aggregate amount (including principal and interest) of
$641,000, and agreed that an advance to the Company in the amount of $75,000
made in November 2006 would also constitute part of the purchase
price.  Southridge agreed to fund the remaining $134,000 upon the
effectiveness of a registration statement, to be filed by the Company, to
register the resales of shares issuable to Southridge upon conversion of the
Southridge Debenture.  The registration statement was filed in January
2007, but as of the date of the Report, had not been declared
effective.
 
 The
Southridge Debenture is convertible into shares of the Company’s Class A common
stock.  The number of shares issuable is determined by dividing the
amount of the Southridge Debenture being converted by the conversion price,
which is the average of the two lowest per share market values for the twenty
trading days immediately preceding the conversion date multiplied by seventy
percent. The conversion price is subject to adjustment as set forth in the
Southridge Debenture.  Southridge has agreed not to convert the
Southridge Debenture to the extent that such conversion would cause Southridge
to beneficially own in excess of 4.999% of the then-outstanding shares of Class
A common stock of the Company except in the case of a merger by the Company or
other organic change.
 
 The
Company also entered into a Registration Rights Agreement (the “Registration
Agreement”) with Southridge pursuant to which the Company agreed to file a
registration statement to register the resale by Southridge of shares of the
Company’s common stock issuable upon conversion of the Southridge Debenture.
Under the Registration Agreement, the Company agreed to file a registration
statement to register the resale by Southridge of up to 300,000,000 shares of
Fonix Class A common stock.
 
 In
addition to the Southridge Debenture, on December 7, 2006, the Company entered
into a Securities Purchase Agreement, dated as of December 1, 2006 (the
“McCormack Agreement”), with McCormack Avenue, Ltd. (“McCormack”), relating to
the purchase and sale of a Series E 9% Secured Subordinated Convertible
Debenture (the “McCormack Debenture”) in the principal amount of
$1,039,000.
 
 Pursuant
to the McCormack Agreement, McCormack paid the purchase price by tendering
outstanding promissory notes in the amounts of $300,000 and $350,000, together
with combined interest thereon of $64,000, and agreed that advances to the
Company in the amount of $325,000, made in September, October, and November
2006, would also constitute part of the purchase price.
 
  F-16
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 The
McCormack Debenture is convertible into shares of the Registrant’s Class A
common stock. The number of shares issuable is determined by dividing the amount
of the Debenture being converted by the conversion price, which is the average
of the two lowest per share market values for the twenty trading days
immediately preceding the conversion date multiplied by seventy percent. The
conversion price is subject to adjustment as set forth in the Debenture.
McCormack agreed not to convert the Debenture to the extent that such conversion
would cause McCormack to beneficially own in excess of 4.999% of the
then-outstanding shares of Class A common stock of the Company except in the
case of a merger by the Company or other organic change.
 
 The
Company also entered into a Registration Rights Agreement (the “McCormack
Registration Agreement”) with McCormack pursuant to which the Company agreed to
file a registration statement to register the resale by McCormack of shares of
the Company’s common stock issuable upon conversion of the
Debenture.  As of the date of this Report, the registration statement
had not been filed.
 
 The
Company received no new capital in connection with the issuance and sale of the
McCormack Debenture.
 
 As the
Series E Debentures are convertible into shares of common stock of the Company,
the Company followed the accounting treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the issuance of
$680,023 due to the value of the conversion feature of the
Debenture.  The liability was calculated using the Black-Scholes
valuation model with the following assumptions: dividend yield of 0%, expected
volatility of 139%, risk-free rate of 5% and expected life of 4
years.  At December 31, 2007, the fair value of the Debenture
derivative liability was $2,502,000, of which $1,754,000 is reported as Series E
Debenture, $171,000 is reported as accrued interest and $577,000 is reported as
part of the derivative liability.
 
 NOTE
7.  PREFERRED STOCK
 
 The
Company’s certificate of incorporation allows for the issuance of preferred
stock in such series and having such terms and conditions as the Company’s board
of directors may designate.
 
 Series A
Convertible Preferred Stock - At December 31, 2007, there were 166,667
shares of Series A convertible preferred stock outstanding.  Holders
of the Series A convertible preferred stock have the same voting rights as
common stockholders, have the right to elect one person to the board of
directors and are entitled to receive a one time preferential dividend of $2.905
per share of Series A convertible preferred stock prior to the payment of any
dividend on any class or series of stock.  At the option of the
holders, each share of Series A convertible preferred stock is convertible into
one share of Class A common stock and in the event that the common stock price
has equaled or exceeded $10 per share for a 15 day period, the shares of Series
A convertible preferred stock will automatically be converted into Class A
common stock.  In the event of liquidation, the holders are entitled
to a liquidating distribution of $36.33 per share and a conversion of Series A
convertible preferred stock at an amount equal to .0375 shares of Class A common
stock for each share of Series A convertible preferred stock.
 
 Series H
Preferred Stock - The Company issued 2,000 shares of 5% Series H
nonvoting, nonconvertible Preferred Stock on February 24, 2004, in connection
with the acquisition of LTEL.  Dividends on the $20,000,000 stated
value of the outstanding Series H Preferred Stock were payable at the rate of 5%
per annum as and when declared by the Board of Directors.  The annual
dividend requirement was $1,000,000.  If dividends were declared on
Fonix's common stock, as a condition of that dividend, Fonix was required to pay
three percent of the aggregate amount of such dividend to the Series H Preferred
Stock.  Dividends on the Series H Preferred Stock were payable in cash
or, at the option of Fonix, in shares of Class A common stock.  The
Company has accrued for the March 31, 2006, June 30, 2006 and the period from
July 1, 2006 through September 7, 2006 dividend payments under the Series H
Preferred Stock, but has not paid the dividends to the holders of the Series H
Preferred Stock as of the date of this report.
 
  F-17
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 On
September 7, 2006, the Company entered into an agreement to exchange the 2,000
shares of Series H Preferred Stock for shares of the Company’s Series L
Preferred Stock.  (See discussion below under “Series L Preferred
Stock.”)  As of December 31, 2007, no shares of Series H Preferred
Stock remained outstanding.
 
 Series I
Convertible Preferred Stock -On October 24, 2003, the Company entered
into a private placement of shares of its Class A common stock with The
Breckenridge Fund, LLC, a New York limited liability company
(“Breckenridge”).  Under the terms of the private placement, the
Company agreed to issue 1,043,478 shares of its Class A common stock to
Breckenridge for $240,000 (the “Private Placement Funds”).
 
 Subsequent
to the Company’s receiving the Private Placement Funds, but before any shares
were issued in connection with the private placement, the Company agreed with
Breckenridge to rescind the private placement of the shares and to restructure
the transaction.  The Company retained the Private Placement Funds as
an advance in connection with the restructured transaction.  The
Company paid no interest or other charges to Breckenridge for use of the Private
Placement Funds.
 
 Following
negotiations with Breckenridge, on January 29, 2004, the Company issued to
Breckenridge 3,250 shares of 8% Series I Convertible Preferred Stock (the
“Series I Preferred Stock”), for an aggregate purchase price of $3,250,000,
including the Private Placement Funds which the Company had already
received.  The Preferred Stock was issued under a purchase agreement
dated as of December 31, 2003.  The Series I Preferred Stock had a
stated value of $1,000 per share.
 
 In
connection with the offering of the Series I Preferred Stock, the Company also
issued to Breckenridge warrants to purchase up to 965,839 shares of the
Company’s Class A common stock at $0.50 per share through December 31, 2008, and
issued 2,414,596 shares of our Class A common stock.
 
 The
Series I Preferred Stock entitled Breckenridge to receive dividends in an amount
equal to 8% of the then-outstanding shares of Preferred Stock.  The
dividends were payable in cash or shares of the Company’s Class A common stock,
at the Company’s option.
 
 On
September 27, 2005, the Company agreed with Breckenridge to settle and
discontinue the pending legal actions with Breckenridge.  The three
actions pending in the Supreme Court of New York, Nassau County, involved (i)
the Company’s claims against Breckenridge for the improper transfer to and
subsequent sale of shares of the Company’s common stock by Breckenridge; (ii)
Breckenridge’s claims against the Company for failure to honor conversion
notices or properly issue shares upon conversion of the Series I Preferred Stock
by Breckenridge; and (iii) Breckenridge’s claims that the Company breached
agreements in connection with the Series I Preferred Stock, and that pursuant to
a security agreement, Breckenridge was entitled to damages and possession of the
pledged collateral (collectively, the “Breckenridge Lawsuits”).
 
 Pursuant
to the settlement of the Breckenridge Lawsuits, the Company entered into a
Mutual Release of Claims Agreement (the “Mutual Release”), pursuant to which the
Company and Breckenridge agreed to settle and dismiss the Breckenridge Lawsuits,
and to release any and all claims against each other relating to any prior
transactions between the Company and Breckenridge.  Pursuant to the
Mutual Release, Breckenridge agreed to assign the remaining shares of Series I
Preferred to Southridge Partners, LP, to release its security interest in the
Company’s intellectual property, and to stipulate to the discontinuance with
prejudice of the Breckenridge Lawsuits.  The Company agreed to the
release of the 2,777,777 Unauthorized Shares of Class A common stock that
occurred in March 2004, which shares were valued at $73,000 and recognized as a
legal settlement expense, and to pay to Breckenridge installment payments (the
“Periodic Payments”) consisting of monthly payments of $130,000 from November
2005 through April 2006, and monthly payments of $165,000 from May 2006 through
December 2006, as well as approximately $397,000 which the Company had
previously paid into an escrow account in connection with the Breckenridge
Lawsuits.
 
 The
Company also entered into an agreement with Breckenridge and Southridge
Partners, LP (“Southridge”) whereby Breckenridge agreed to assign to Southridge
all remaining shares of the Company’s Series I Preferred, consisting of
approximately 1,172 shares, together with all of Breckenridge’s rights,
interests, duties, and obligations which Breckenridge received in connection
with the purchase from the Company of the Series I Preferred
Stock.  Southridge paid approximately $1,203,000 for Breckenridge’s
rights to the Series I Preferred Stock and accepted the assignment of the shares
of Series I Preferred Stock and all assigned rights, interests, duties, and
obligations, and the Company consented to the assignment.
 
  F-18
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 Southridge
is not affiliated with Fonix Corporation or its
subsidiaries.  Southridge Partners, LP, is an entity managed by
Southridge Capital Management.
 
 The
effect of the Assignment Agreement was to terminate the Company’s rights,
duties, and obligations relating to the Series I Preferred Stock with respect to
Breckenridge, and to enter into a new agreement relating to such rights, duties,
and obligations with Southridge.
 
 Additionally,
the Company entered into a Security Agreement with Breckenridge relating to
certain of its obligations in connection with the agreement with Breckenridge to
discontinue the Breckenridge Lawsuits.  Pursuant to the settlement
agreement between the parties, the Company is required to make the Periodic
Payments to Breckenridge.  To secure those payments, the Company
granted to Breckenridge a security interest in the proceeds that it receives in
connection with draws on the Seventh Equity Line of Credit and any subsequent
equity line-type financings in the event that we do not make a Periodic Payment
when due.  Specifically, the Company granted to Breckenridge the right
to receive proceeds from its draws on the Seventh Equity Line and any subsequent
equity line-type financings to the extent that we do not make a payment as
required and after the applicable grace period or cure period has
run.  With respect to future equity line-type financings, the Company
agreed to include in the documentation of such financings provisions granting to
Breckenridge the right to make draws and to receive funds directly from the
equity line provider in the event that we fail to make a payment as required,
and then only to the extent of the amount of the payment.
 
 For the
year ended December 31, 2004, the Company issued 8,435,869 shares of the
Company’s Class A common stock in response to conversion requests for 1,000
shares of Series I Preferred Stock.  For the year ended December 31,
2005, the Company issued 18,482,083 shares of the Company’s Class A common stock
in response to conversion request for 1,078 shares of Series I Preferred
Stock.  As of December 31, 2007, no shares of Series I Preferred Stock
remained outstanding.
 
 Series J
Preferred Stock – On October 6, 2005, the Company entered into a Series J
5% Convertible Preferred Stock Exchange Agreement (the "Exchange Agreement")
with Southridge Partners, LP ("Southridge"), a Delaware limited
partnership.  Pursuant to the Exchange Agreement, Southridge exchanged
all of the shares of Series I Preferred Stock that it acquired from
Breckenridge, for 1,452 shares of the Company's Series J 5% Convertible
Preferred Stock (the "Series J Preferred Stock").
 
 Because
the shares of Series J were issued in exchange for the remaining outstanding
shares of Series I Preferred Stock, we did not receive any proceeds in
connection with the issuance of the Series J Preferred Stock.  The
Company issued 1,452 shares of Series J Preferred Stock in exchange for 1,172
shares of Series I Preferred Stock.  Of the 280 additional shares that
were issued to Southridge, 250 were issued as a placement fee and were accounted
for in the selling, general and administrative expense in the accompanying
financial statements.  The remaining 30 shares were issued as
additional litigation expense and were accounted for as legal settlement
expense.
 
 The
Series J Preferred Stock entitles Southridge to receive dividends in an amount
equal to 5% of the then-outstanding balance of shares of Series J Preferred
Stock.  The dividends are payable in cash or shares of the Company's
Class A common stock, at the Company's option.
 
 The
Series J Preferred Stock may be converted into common stock of the Company at
the option of the holder by using a conversion price which shall be 90% of the
average of the two (2) lowest closing bid prices for the twenty-day trading
period prior to the conversion date.
 
 Redemption
of the Series J Preferred Stock, whether at our option or that of Southridge,
requires us to pay, as a redemption price, the stated value of the outstanding
shares of Series J Preferred Stock to be redeemed, together with any accrued but
unissued dividends thereon, multiplied by one hundred ten percent
(110%).
 
  F-19
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 For the
year ended December 31, 2005, the Company issued 3,795,918 shares of its Class A
common stock upon conversion of 93 shares of its Series J Preferred
Stock.  For the year ended December 31, 2006, the Company issued
15,028,249 shares of its Class A common stock upon conversion of 266 shares of
Series J Preferred Stock.  As of December 31, 2007, no shares of
Series J Preferred Stock remained outstanding.
 
 Series K
Preferred Stock – On February 3, 2006, the Company’s Board of Directors
approved the designation and issuance of Series K 5% Convertible Preferred Stock
(the “Series K Preferred Stock”). The Series K Preferred Stock entitled the
holder to receive dividends in an amount equal to 5% of the stated value of the
then-outstanding balance of shares of Series K Preferred Stock.  The
dividends were payable in cash or shares of the Company’s Class A common stock,
at the Company’s option.
 
 The
shares of Series K Preferred Stock were issued pursuant to a Series K 5%
Convertible Preferred Stock Exchange Agreement (the “Series K Agreement”), in
connection with which Southridge exchanged 1,093 shares of Series J Convertible
Preferred Stock for 1,093 shares of Series K Convertible Preferred
Stock.
 
 The
Series K Preferred Stock were convertible into common stock of the Company at
the option of the holder by using a conversion price of $0.01 per
share.
 
 For year
ended December 31, 2006, the Company issued 109,300,000 shares of its Class A
common stock upon conversion of all 1,093 shares of its Series K Preferred
Stock.  As of December 31, 2007, no shares of Series K Preferred Stock
remained outstanding.
 
 Series L
Preferred Stock – On September 7, 2006, the Company entered into a Series
L 9% Convertible Preferred Stock Exchange Agreement (the "Exchange Agreement")
with McCormack and Kenzie Financial (“Kenzie”), a British Virgin Islands
company.  Pursuant to the Exchange Agreement, McCormack and Kenzie
exchanged all 2,000 shares of Series H Preferred Stock that
they  acquired from the sale of LTEL Holdings, for 1,960.8 and 39.2
shares, respectively,  of the Company's Series L 9% Convertible
Preferred Stock (the "Series L Preferred Stock").
 
 Because
the shares of Series L Preferred Stock were issued in exchange for the remaining
outstanding shares of Series H Preferred Stock, the Company did not receive any
proceeds in connection with the issuance of the Series L Preferred
Stock.
 
 The
Series L Preferred Stock entitles McCormack and Kenzie to receive dividends in
an amount equal to 9% of the then-outstanding balance of shares of Series L
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.
 
 The
Series L Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price which was 80% of the average of
the two (2) lowest closing bid prices for the twenty-day trading period prior to
the conversion date.
 
 Redemption
of the Series L Preferred Stock, whether at the Company’s option or that of
McCormack or Kenzie, requires the Company to pay, as a redemption price, the
stated value of the outstanding shares of Series L Preferred Stock to be
redeemed, together with any accrued but unissued dividends thereon, multiplied
by one hundred ten percent (110%).
 
 In
connection with the issuance of the Series L Preferred Stock, the Company filed
with the State of Delaware a Certificate of Designation and Series L 9%
Convertible Stock Terms (the “Series L Terms”), which become a part of the
Company’s Certificate of Incorporation, as amended.
 
  F-20
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 The
Company accounted for the exchange as redemption of the outstanding Series H
Preferred Stock as the Series H Preferred Stock was not convertible into shares
of common stock of the Company.  The Series L Preferred Stock is
convertible into shares of common stock of the Company.  The Company
followed the accounting treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the redemption of
$30,991,000 due to the value of the conversion feature of the Series L Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 140%, risk-free rate of 3.75% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
L Preferred Stock, no value was prescribed to the Series L Preferred
Stock.  Also in connection with the redemption, the Company recognized
a preferred stock dividend of $16,000,000, equal to the original discount the
Company had assigned to the Series H Preferred Stock.  At December 31,
2007, the fair value of the Series L Preferred Stock derivative liability was
$16,148,000.
 
 For the
year ended December 31, 2006, the Company issued 489,870,090 shares of our Class
A common stock in conversion of 142 shares of its Series L Preferred
Stock.  For the year ended December 31, 2007, the Company issued
2,777,153,205 shares of our Class A common stock in conversion of 173 shares of
its Series L Preferred Stock.  The Company exchanged 150 shares of
Series L Preferred Stock for 150 shares of Series M Preferred Stock as discussed
below.  At December 31, 2007, 1,535 shares of Series L Preferred Stock
remained outstanding.  Subsequent to December 31, 2007 and through
March 31, 2008, the Company issued 1,404,251,012 shares of our Class A common
stock in conversion of 16 shares of Series L Preferred Stock.
 
 Series M
Preferred Stock– On April 4, 2007, the Company entered into a Series M
9% Convertible Preferred Stock Exchange Agreement with Sovereign Partners, LP
(“Sovereign”).  Pursuant to the exchange agreement, Sovereign
exchanged 150 shares of the Company’s Series L Preferred Stock for 150 shares of
the Company’s Series M 9% Convertible Preferred Stock (the “Series M Preferred
Stock”).
 
 The
Series M Preferred Stock entitles Sovereign or its assignees to receive
dividends in an amount equal to 9% of the then-outstanding balance of shares of
Series M Preferred Stock.  The dividends are payable in cash or shares
of the Company’s Class A common stock, at the Company’s option.
 
 The
Series M Preferred Stock may be converted into common stock of the Company at
the option of the holder by using a conversion price which shall be the lower of
(i) 80% of the average of the two lowest closing bid prices for the twenty-day
trading period prior to the conversion date, or (ii) $0.004.
 
 Redemption
of the Series M Preferred Stock, whether at the Company’s option or that of
Sovereign, requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series M Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).
 
 Because
the shares of Series M were issued in exchange for the outstanding shares of
Series L Preferred Stock, the Company did not receive any proceeds in connection
with the issuance of the Series M Preferred Stock.
 
 The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the redemption of
$1,603,000 due to the value of the conversion feature of the Series M Preferred
Stock, which was previously recorded as part of the Series L Preferred Stock
derivative liability.  The liability was calculated using the
Black-Scholes valuation model with the following assumptions: dividend yield of
0%, expected volatility of 134%, risk-free rate of 5% and expected life of 4
years.  As the value of the derivative liability was greater than the
face value of the Series M Preferred Stock, no value was prescribed to the
Series M Preferred Stock.  At December 31, 2007 the fair value of the
Series M Preferred Stock derivative liability was $1,577,000.
 
 Series N
Convertible Preferred Stock – On August 24, 2007, the Company entered
into a Securities Purchase Agreement with Trillium Partners, LP and other
unnamed future investors relating to the issuance and sale of the Company’s
Series N 9% Convertible Preferred Stock.
 
  F-21
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 Pursuant
to the agreement, the Company agreed to issue up to 2,400 shares of its Series N
9% Convertible Preferred Stock (the “Series N Preferred Stock”) at a per share
price of $1,000 to Trillium Partners, LP and other unnamed future investors, for
gross proceeds of up to $2,400,000.  As of the date of this report,
the Company had issued 1,350 shares of the Series N Preferred Stock, for cash
proceeds of $1,350,000.
 
 The
Series N Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series L
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.
 
 The
Series N Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price, equal to 80% of the average of
the two lowest closing bid prices for the twenty-day trading period prior to the
conversion date.
 
 Redemption
of the Series N Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series N Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).
 
 The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the redemption of
$957,000 due to the value of the conversion feature of the Series N Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 128%, risk-free rate of 5.0% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
N Preferred Stock, no value was prescribed to the Series N Preferred
Stock.  At December 31, 2007, the fair value of the Series N Preferred
Stock derivative liability was $1,109,000.
 
 Fonix Speech,
Inc. Series B Convertible Preferred Stock – On April 4, 2007, the Company
entered into a Securities Purchase Agreement by and among the Company, Fonix
Speech, Inc. (“FSI”), and Sovereign Partners, LP (“Sovereign”).  FSI
is a wholly owned subsidiary of the Company.
 
 Pursuant
to the FSI agreement, FSI sold 125 shares of its Series B 9% Convertible
Preferred Stock (the “Series B Preferred Stock”) at a per share price of $10,000
to Sovereign, for gross proceeds of $1,250,000.
 
 The
shares of Series B Preferred Stock are convertible into shares of the Company’s
Class A common stock.  The Series B Preferred Stock may be converted
into common stock of the Company at the option of the holder by using a
conversion price which shall be the lower of (i) 80% of the average of the two
lowest closing bid prices for the twenty-day trading period prior to the
conversion date, or (ii) $0.004.
 
 The
Series B Preferred Stock entitles Sovereign or its assignees to receive
dividends in an amount equal to 9% of the then-outstanding balance of shares of
Series B Preferred Stock.  The dividends are payable in cash or shares
of the Company's Class A common stock, at the Company's option
 
 The
Company followed the accounting treatment in SFAS 150 “Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity,”SFAS
133 “Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19 “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”The Company recognized a derivative liability upon the issuance of
$1,336,207 due to the value of the conversion feature of the Series B Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 134%, risk-free rate of 5% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
B Preferred Stock, no value was prescribed to the Series B Preferred
Stock.  At December 31, 2007, the fair value of the Series B Preferred
Stock derivative liability was $1,314,000.
 
  F-22
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 NOTE
8.  EQUITY LINES OF CREDIT
 
 Sixth Equity Line
of Credit – On November 15, 2004, the Company entered into a sixth
private equity line agreement (the “Sixth Equity Line Agreement”) with the
Equity Line Investor, on terms substantially similar to those of the previous
equity lines.  Under the Sixth Equity Line Agreement, the Company has
the right to draw up to $20,000,000 against an equity line of credit (“the Sixth
Equity Line”) from the Equity Line Investor.  The Company is entitled
under the Sixth Equity Line Agreement to draw certain funds and to put to the
Equity Line Investor shares of the Company’s Class A common stock in lieu of
repayment of the draw.  The number of shares to be issued is
determined by dividing the amount of the draw by 90% of the average of the two
lowest closing bid prices of the Company’s Class A common stock over the ten
trading days after the put notice is tendered.  The Equity Line
Investor is required under the Sixth Equity Line Agreement to tender the funds
requested by the Company within two trading days after the ten-trading-day
period used to determine the market price.
 
 In
connection with the Sixth Equity Line Agreement, the Company granted
registration rights to the Equity Line Investor and filed a registration
statement on Form S-2, which covered the resales of the shares to be issued
under the Sixth Equity Line.  The Company is obligated to maintain the
effectiveness of the registration statement.
 
 For the
year ended December 31, 2005, the Company received $4,263,000 in funds drawn
under the Sixth Equity Line, less commissions and fees of
$141,000.  The Company issued 75,000,000 shares of Class A common
stock to the Equity Line Investor as puts under the Sixth Equity Line, totaling
$4,138,000.
 
 Seventh Equity
Line of Credit - On May 27, 2005, the Company entered into a seventh
private equity line agreement (the "Seventh Equity Line Agreement") with the
Equity Line Investor, on terms substantially similar to those of the Sixth
Equity Line between Queen and the Company dated November 15, 2004.
 
 Under the
Seventh Equity Line Agreement, the Company had the right to draw up to
$20,000,000 against an equity line of credit (the "Seventh Equity Line") from
the Equity Line Investor.  The Company was entitled under the Seventh
Equity Line Agreement to draw certain funds and to put to the Equity Line
Investor shares of the Company's Class A common stock in lieu of repayment of
the draw.  The Company was limited as to the amount of shares it may
put to the Equity Line Investor in connection with each put; the Company could
not put shares which would cause the Equity Line Investor to own more than 4.99%
of its outstanding common stock on the date of the put notice.  The
number of shares to be issued in connection with each draw was determined by
dividing the amount of the draw by 93% of the average of the two lowest closing
bid prices of our Class A common stock over the ten trading days after the put
notice is tendered.  The Equity Line Investor was required under the
Seventh Equity Line Agreement to tender the funds requested by the Company
within two trading days after the ten-trading-day period used to determine the
market price.
 
 The
Company granted registration rights to the Equity Line Investor and filed three
registration statements which cover the resales of the shares to be issued under
the Seventh Equity Line.  All of the shares registered by the first
registration statement had been sold as of October 24, 2005.  The
second registration statement filed in connection with the Seventh Equity Line
was declared effective by the SEC on February 10, 2006.  All of the
shares registered by the second registration statement had been sold as of July
26, 2006.  The Company filed a third registration statement on June
26, 2006, to register additional shares under the Seventh Equity
Line.  However, that registration statement was not declared
effective, and no shares were sold under that registration
statement.
 
 For the
year ended December 31, 2005, the Company received $3,127,000 in funds drawn
under the Seventh Equity Line, less commissions and fees of
$106,000.  The Company issued 100,000,000 shares of Class A common
stock to the Equity Line Investor as puts under the Seventh Equity Line totaling
$3,127,000.
 
 For the
year ended December 31, 2006, the Company received $3,378,000 in funds drawn
under the Seventh Equity Line, less commissions and fees of
$114,000.  The Company issued 300,000,000 shares of Class A common
stock to the Equity Line Investor as puts under the Seventh Equity Line totaling
$3,378,000.
 
 In
January, 2007, the Company terminated the Seventh Equity Line, and the Company
has withdrawn the third registration statement related to the Seventh Equity
Line.  As such, as of the date of this Report, the Company did not
have an equity line of credit financing available to it.
 
  F-23
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 NOTE
9.  COMMON STOCK
 
 Common
Stock– During
2007, the Company issued 2,977,153,205 shares of Class A common
stock.  Of such shares, 2,777,153,205 shares were issued in conversion
of 173 shares of Series L Preferred Stock and 200,000,000 shares were issued for
consulting services.
 
 During
2006, the Company issued 917,036,751 shares of Class A common
stock.  Of such shares,  300,000,000 were issued in
connection with draws on the Seventh Equity Line, 15,028,249 shares were issued
in conversion of 266 shares of Series J Preferred Stock, 109,300,000 shares were
issued in conversion of 1,093 shares of Series K Preferred Stock, 2,838,412
shares were issued in payment of dividends on Series H Preferred Stock and
489,870,090 shares were issued in conversion of 142 shares of Series L Preferred
Stock.
 
 During
2005, the Company issued 261,157,897 shares of Class A common
stock.  Of such shares, 180,480,405 were issued upon conversion of
draws on the equity lines, 29,417,578 were issued in payment of principal and
interest on long-term debt, 27,275,299 were issued in payment of dividends on
Series H Preferred Stock, 18,482,083 were issued in connection with conversions
of Series I Preferred Stock, 3,795,918 were issued in connection with
conversions of Series J Preferred Stock and 2,277,777 were issued in connection
with legal settlement.
 
 NOTE
10.  STOCK OPTIONS AND WARRANTS
 
 Common Stock
Options - In 1998, the Company’s board of directors and shareholders
approved the 1998 Stock Option and Incentive Plan (“the “1998 Plan”) for
directors, employees and other persons acting on behalf of the Company, under
which the aggregate number of shares authorized for issuance was
250,000.  The Company subsequently determined that it had issued
253,581 options in excess of the aggregate number authorized under the
plan.  In 2004, the Company’s board of directors approved an increase
in the number of shares under the Plan from 250,000 to 550,000 to cover the
additional options issued.  In November 2004, the Board of Directors
again amended the 1998 Plan to increase the aggregate number of shares under the
1998 Plan from 550,000 to 20,000,000.  The purpose of this amendment
is to cover any additional issuances of shares made in excess of the number
authorized under the 1998 Plan and to enable the Company to issue additional
incentive stock options to key employees and non-qualified stock options, stock
appreciation rights, cash and stock bonuses and other incentive grants to
directors, employees and certain non-employees who have important relationships
with the Company or its subsidiaries.  At a meeting of shareholders
held on December 30, 2004, the amendments to the 1998 Plan were
approved.  As of December 31, 2007, there were 19,092,358 shares
available for grant under this plan.
 
 In 1997,
the Company’s board of directors approved the 1997 Stock Option and Incentive
Plan for directors, employees and other persons acting on behalf of the Company,
under which the aggregate number of shares authorized for issuance is
187,500.  As of December 31, 2007, there were 187,500 shares available
for grant under this plan.
 
 In 1996,
the Company’s board of directors and shareholders approved the 1996 Directors’
Stock Option Plan, under which the aggregate number of shares of Class A common
stock authorized for issuance is 135,000.  The plan provides that each
director shall receive options to purchase 5,000 shares of Class A common stock
for services rendered as a director during each entire calendar year or portion
of a calendar year in excess of six months.  The exercise price of
such options is the closing market price of the Class A common stock on the date
the options are granted.  The option term is 10 years from date of
grant.  As of December 31, 2007, shares available for grant under this
plan were 135,000.
 
 In 1996,
the Company’s board of directors approved a Long-Term Stock Investment and
Incentive Plan for officers, key employees and other persons acting on behalf of
the Company under which the aggregate number of shares authorized for issuance
is 22,500.  The exercise price of these options is the closing market
price of the Class A common stock on the date the options are
granted.  The term of the plan is 10 years and options are subject to
a three-year vesting schedule, pursuant to which one-third of the total number
of options granted may be exercised each year.  As of December 31,
2007, shares available for grant under this plan were 22,500.
 
  F-24
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 On
January 19, 2005 the Company entered into an option exchange program with its
employees, wherein the Company gave eligible Fonix employees the opportunity to
exchange outstanding stock options for the same number of new options to be
issued at least six months and one day from the expiration of the
offer.  As a result of the option exchange program, the Company
cancelled 414,450 options to purchase shares of our Class A common stock
effective February 22, 2005.  On August 23, 2005 the Company granted
414,450 options to employees participating in the option exchange program at
$0.04 per share.
 
 During
2005, the Company granted options to purchase 746,505 shares of Class A common
stock in addition to the options granted in connection with the option exchange
program described above.  The options were granted at exercise prices
ranging from $0.04 to $0.12.  All options were granted at the quoted
market price on the date of grant.  All options granted vest over
three years following issuance.  If not exercised, all options expire
within ten years from the date of grant.
 
 During
2006, the Company granted options to purchase 58,000 shares of Class A common
stock at exercise prices ranging from $0.01 to $0.02.  All options
were granted at the quoted market price on the date of grant.  All
options granted vest over three years following issuance.  If not
exercised, all options expire within ten years from the date of
grant.
 
 During
2007, the Company granted no options to employees.
 
 A summary
of options granted under the Company’s various stock option plans for the years
ended December 31, 2007, 2006, and 2005, is presented below:
 
 2007
                
                
                2006
                
                
                2005Stock
      Options
                
                
                Weighted
      Average Exercise Price
                
                
                Stock
      Options
                
                
                Weighted
      Average Exercise Price
                
                
                Stock
      Options
                
                
                Weighted
      Average Exercise PriceOutstanding
      at beginning of the year
                
                
                907,642
                
                
                $
                0.13
                
                
                
                1,331,205
                
                
                $
                0.132
                
                
                
                818,920
                
                
                $
                42.42Granted
                
                
                -
                
                
                
                -
                
                
                
                58,000
                
                
                
                0.01
                
                
                
                1,160,955
                
                
                
                0.09Exercised
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Forfeited
                
                
                (531,142
                )
                
                
                0.15
                
                
                
                (481,563
                )
                
                
                0.13
                
                
                
                (647,810
                )
                
                
                59.11Outstanding
      at end of the year
                
                
                376,500
                
                
                
                0.10
                
                
                
                907,642
                
                
                
                0.13
                
                
                
                1,331,205
                
                
                
                0.13Exercisable
      at the end of the year
                
                
                363,834
                
                
                $
                0.11
                
                
                
                776,774
                
                
                $
                0.13
                
                
                
                635,303
                
                
                $
                0.13
 
 A summary
of options outstanding and options exercisable under the Company’s various stock
option plans at December 31, 2007, is presented below:
 
 
 Options
      Outstanding
                
                
                Options
      ExercisableRange
      of Exercise Prices
                
                
                Number
      Outstanding
                
                Weighted
      Average Remaining Contractual Life
                
                Weighted
      Average Exercise Price
                
                
                Number
      Exercisable
                
                
                Weighted
      Average Exercise Price$
                0.01
      – 0.04
                
                
                
                339,313
                
                3.1
      years
                
                $
                0.04
                
                
                
                332,647
                
                
                $
                0.040.12
                
                
                
                18,000
                
                7.8
      years
                
                
                0.12
                
                
                
                12,000
                
                
                
                0.120.26
                
                
                
                17,000
                
                6.5
      years
                
                
                0.26
                
                
                
                17,000
                
                
                
                0.263.60
      – 61.24
                
                
                
                2,187
                
                3.7
      years
                
                
                8.76
                
                
                
                2,187
                
                
                
                8.76$
                0.01
      – 61.24
                
                
                
                376,500
                
                6.2
      years
                
                
                0.10
                
                
                
                363,834
                
                
                
                0.11
 
  F-25
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 The
weighted average fair value of options granted during the years ended December
31, 2006, and 2005 were $0.01 and $0.09 per share, respectively.  The
options outstanding at December 31, 2007 had an aggregate intrinsic value of
zero.
 
 The fair
value of options and warrants is estimated on the date granted using the
Black-Scholes option pricing model with the following weighted-average
assumptions used for grants during 2006, and 2005:
 
 2006
                
                2005Risk-free
      interest rate
                
                3.75%
                
                3.75%Expected
      dividend yield
                
                0.0%
                
                0.0%Expected
      exercise lives
                
                5
      years
                
                5
      yearsExpected
      volatility
                
                143%
                
                143%
 
 The
estimated fair value of options granted is subject to the assumptions made, and
if the assumptions were to change the estimated fair value amounts could be
significantly different.
 
 Warrants -
A summary of warrants granted by the Company during the years ended December 31,
2007, 2006, and 2005, is presented below:
 
 2007
                
                
                2006
                
                
                2005Shares
                
                
                Weighted
      Average Exercise Price
                
                
                Shares
                
                
                Weighted
      Average Exercise Price
                
                
                Shares
                
                
                Weighted
      Average Exercise PriceOutstanding
      at beginning of the year
                
                
                15,000
                
                
                $
                40.00
                
                
                
                15,000
                
                
                $
                40.00
                
                
                
                980,389
                
                
                $
                1.10Granted
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —Forfeited
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (965,389
                )
                
                
                0.51Outstanding
      at end of the year
                
                
                15,000
                
                
                
                40.00
                
                
                
                15,000
                
                
                
                40.00
                
                
                
                15,000
                
                
                
                40.00Exercisable
      at end of the year
                
                
                15,000
                
                
                
                40.00
                
                
                
                15,000
                
                
                
                40.00
                
                
                
                15,000
                
                
                
                40.00
 
 NOTE
11.  RELATED-PARTY TRANSACTIONS
 
 The
secretary of the Company is a partner in a law firm that the Company uses to
provide legal services.  During 2007, 2006 and 2005, the Company
incurred expenses of approximately $207,000, $368,000 and $533,000,
respectively, to the law firm for services provided to the Company.
 
 NOTE
12.  INCOME TAXES
 
 At
December 31, 2007 and 2006, net deferred income tax assets, before considering
the valuation allowance, totaled $58,731,000 and $64,313,000,
respectively.  The amount and ultimate realization of the benefits
from the deferred income tax assets are dependent, in part, upon the tax laws in
effect, the Company’s future earnings, and other future events, the effects of
which cannot be determined.  The Company has established a valuation
allowance for all deferred income tax assets not offset by deferred income tax
liabilities due to the uncertainty of their realization.  The net
change in the valuation allowance was an decrease of $5,582,000 for 2007, an
increase of $8,187,000 for 2006 and a decrease of $8,249,000 for
2005.
 
 At
December 31, 2007, the Company has unused federal net operating loss
carryforwards available of approximately $142,985,000 and unused state net
operating loss carryforwards of approximately $134,265,000 which may be applied
against future taxable income, if any, and which expire in various years from
2011 through 2027.  The Internal Revenue Code contains provisions
which likely will reduce or limit the availability and utilization of these net
operating loss carryforwards.  For example, limitations are imposed on
the utilization of net operating loss carryforwards if certain ownership changes
have taken place or will take place.  The Company has not performed an
analysis to determine whether any such limitations have occurred.
 
  F-26
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 The
temporary differences and carryforwards which give rise to the deferred income
tax assets as of December 31, 2007 and 2006 are as follows:
 
 Deferred
      income tax assets:
                
                2007
                
                
                2006Net
      operating loss carryforwards:Federal
                
                $
                48,614,944
                
                
                $
                54,163,000State
                
                
                4,430,748
                
                
                
                4,969,000Research
      expenditures credits
                
                
                2,511,887
                
                
                
                2,487,000Accrued
      liabilities
                
                
                115,548
                
                
                
                86,000Deferred
      revenues
                
                
                166,133
                
                
                
                172,000Amortization
      of intangible assets
                
                
                2,891,700
                
                
                
                2,437,000Total
      deferred income tax assets
                
                
                58,730,960
                
                
                
                64,313,000Valuation
      allowance
                
                
                (58,730,960
                )
                
                
                (64,313,000
                )Deferred
      income tax liability – intangible telecommunications
assets
                
                
                –
                
                
                
                –Net
      deferred income tax assets
                
                $
                –
                
                
                $
                –
  A
reconciliation of income taxes at the federal statutory rate to the Company’s
effective rate is as follows:
 
 Year
      Ended December 31,2007
                
                
                2006
                
                
                2005Federal
      statutory income tax rate
                
                
                34.0%
                
                
                
                34.0%
                
                
                
                34.0%State
      and local income tax rate, net of federal benefit
                
                
                3.3
                
                
                
                3.3
                
                
                
                3.3Non-deductible
      items
                
                
                (0.5
                )
                
                
                (0.5
                )
                
                
                (0.5
                )Valuation
      allowance
                
                
                (37.2
                )
                
                
                (37.2
                )
                
                
                (37.2
                )Effective
      income tax rate
                
                
                0.0%
                
                
                
                0.0%
                
                
                
                0.0%
 
 NOTE
13.  COMMITMENTS AND CONTINGENCIES
 
 Executive
Employment Agreements– As of December 31, 2007, the Company had employment agreements with two
executive officers that were initiated November 1, 1996 and amended effective
January 31, 2000 to extend the term of the agreements and reduce the base
compensation.  The current annual base salary for each executive
officer was $309,400.  During 2002, the executive officers agreed to
accept reduced cash compensation pursuant to the Company’s 2002 Employee
Compensation Plan.  The current expiration date of the agreements is
December 31, 2010.
 
 In the
event that, during the contract term, both a change of control occurs, and
within six months after such change in control occurs, the executive’s
employment is terminated by the Company for any reason other than cause, death,
or retirement, the executive shall be entitled to receive an amount in cash
equal to all base salary then and thereafter payable within 30 days of
termination.
 
 On March
5, 2008 Mr. Murdock resigned as President, Chairman, and Chief Executive
Officer.
 
 
 
  F-27
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 In
connection with his resignation from the Company and its subsidiaries, Mr.
Murdock entered into a Separation and Release of Claims Agreement (the
“Separation Agreement”) with the Company.  Under the Separation
Agreement, the parties agreed that the Company is not obligated to pay to Mr.
Murdock approximately $320,000 in deferred salary owed to Mr. Murdock unless and
until (i) the occurrence of a Liquidity Event (as defined in the Agreement), and
then in proportion to the amount that Mr. Dudley is paid for salary that he also
deferred during the deferred salary period or (ii) the Company begins to make
payments to Dudley for salary which he has deferred for the deferred salary
period, and then in proportion to the amount that Mr. Dudley is paid for salary
that he deferred during the deferred salary period, or (ii) the conversion by
Murdock into shares of the Company's Common Stock at any time or times on or
after the date of the Agreement, at Mr. Murdock’s sole option, any portion of
the outstanding and unpaid deferred salary into fully paid and nonassessable
shares of the Company’s Common Stock, with the number of shares issuable being
determined by dividing the salary amount being converted by the conversion price
(which is equal to the average of the closing bid prices over the ten (10)
trading days prior to the conversion date). Additionally, the parties agreed
that Mr. Murdock was not entitled to any severance under his Employment
Agreement, except that upon the occurrence of a Liquidity Event, then the
Company is required to pay to Mr. Murdock an amount which is equal to the lower
of (i) his annual base salary or (ii) the severance paid to Mr. Dudley in
connection with such Liquidity Event.
 
 The
Company also agreed (i) to provide COBRA medical coverage for Mr. Murdock
through December 31, 2009; (ii) that all of Mr. Murdock’s stock options,
warrants, and other similar rights would immediately vest; (iii) that the
Company would maintain life insurance, disability insurance, and 401(k) plan for
Mr. Murdock through December 31, 2009; (iv) to indemnify Mr. Murdock against
claims relating to his service as an officer and director of Fonix, as well as
in connection with the lawsuits by The Breckenridge Fund LLC; (v) that unpaid
expenses of approximately $25,000 owed to Mr. Murdock would be paid to Mr.
Murdock at the time of a Liquidity Event (as defined in the Agreement); and (vi)
to pay as and when due in regular monthly installments the balance of
approximately $24,000 under the terms a loan from the Company’s 401(k) plan, as
lender, to Mr. Murdock, as borrower.
 
 Under the
Separation Agreement, Mr. Murdock agreed, among other this, (i) to release the
Company and its officers, directors, and employees from any claims; and (ii)
that he would not make us of or disclose any proprietary business or trade
secret information.
 
 Mr.
Dudley’s executive employment agreement, as described above remained in force as
the date of this Report.
 
 Operating Lease
Agreements - The Company leases certain facilities and equipment used in
its operations.  The amounts of commitments for non-cancelable
operating leases in effect at December 31, 2007, were as follows:
 
 Year ending December
      31,2008
                
                $
                312,0002009
                
                
                312,0002010
                
                
                208,000$
                832,000
 
 The
Company incurred rental expense of $382,000, $350,000, $829,000 during 2007,
2006 and 2005, respectively, related to these leases.
 
 Forgiveness of
Trade Payables and Accrued Interest - The Company negotiated reductions
in amounts due various trade vendors amounting to $199,000, $0 and $142,000
during 2007, 2006 and 2005 respectively.
 
 NOTE
14.  LITIGATION
 
 Breckenridge Complaint – On
June 6, 2006, Breckenridge filed a complaint against the Company in the Supreme
Court of the State of New York, County of Nassau (the “Court”), in connection
with a settlement agreement between the Company and Breckenridge entered into in
September 2005. In the Complaint, Breckenridge alleged that the Company failed
to pay certain amounts due under the settlement agreement in the amount of
$450,000. The Company denied the allegations of Breckenridge’s complaint and
filed a motion for summary judgment.  Breckenridge also filed for
summary judgment on its complaint.
 
 On
February 2, 2007, the Court granted Breckenridge’s motion for summary judgment,
denied the Company’s summary judgment motion, and directed that a hearing be
held to determine the amount owed by the Company to Breckenridge.  The
Company and Breckenridge entered into a stipulation that the Company owed
Breckenridge $1,530,000 plus interest at a rate of 9% from September 15, 2006 to
the date of entry of judgment.
 
  F-28
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 The
Court’s judgment, dated as of March 15, 2007, states that the Company owes an
aggregate of $1,602,000 to Breckenridge.  The Company has accrued for
this settlement in the accompanying financial statements.  In February
2008, the Company entered into an amended settlement agreement with Breckenridge
under which the Company agreed to pay Breckenridge $540,000.  The
Company has paid Breckenridge $242,500 and is obligated to pay the balance of
$297,500 at the rate of $42,500 per month.
 
 Hite Development Corporation v. Fonix
Corporation,Third District Court, Salt Lake County (Civil No.
070900883).  In January 2007, Hite Development Corporation (“Hite”)
brought a lawsuit against the Company claiming breach of contract and breach of
the covenant of good faith and fair dealing, alleging that the Company failed to
make certain payments under a settlement agreement with Hite dating from March
2005.  The complaint seeks approximately $33,000 plus
interest.  The Company filed its answer in May 2007.  The
case is currently in the discovery phase.  The Company intends to
defend against the claims in the complaint.
 
 RR Donnelley Receivables Inc. v.
Fonix Corporartion,Third District Court, Salt Lake County (Civil No.
070412088).  In July 2007, RR Donnelley Receivables Inc. (“Donnelly”)
brought a lawsuit against the Company for alleged failure to pay for services
provided.  The complaint seeks approximately $21,000 plus
interest.  The Company filed its answer in August 2007, and filed a
motion to dismiss the action in December 2007.  That motion is
currently pending before the court.  If the Company’s motion to
dismiss is denied, the Company intends to defend against the claims in the
complaint.
 
 NOTE
15.  EMPLOYEE PROFIT SHARING PLAN
 
 The
Company has a 401(k) profit sharing plan covering essentially all of its
full-time employees.  Under the plan, employees may reduce their
salaries, in amounts allowed by law, and contribute the salary reduction amount
to the plan on a pretax basis.  The plan also allows the Company to
make matching and profit sharing contributions as determined by the board of
directors.  To date, no matching or profit sharing contributions have
been made by the Company.
 
 NOTE
16.  SIGNIFICANT CUSTOMERS
 
 The
Company’s revenues by geographic region for the years ended December 31, 2006,
2005 and 2004 were:
 
 2007
                
                
                2006
                
                
                2005United
      States
                
                $
                913,000
                
                
                
                50%
                
                
                $
                546,000
                
                
                
                41%
                
                
                $
                898,000
                
                
                
                66%Asia
      Pacific
                
                
                830,000
                
                
                
                45%
                
                
                
                591,000
                
                
                
                44%
                
                
                
                352,000
                
                
                
                26%Other
                
                
                95,000
                
                
                
                5%
                
                
                
                192,000
                
                
                
                15%
                
                
                
                108,000
                
                
                
                8%$
                1,838,000
                
                
                
                
                
                
                $
                1,329,000
                
                
                
                
                
                
                $
                1,358,000
 
 For the
year ended December 31, 2007, four customer accounted for 20%, 15%, 12% and 10%
of total revenues.  For the year ended December 31, 2006, one customer
accounted for 31% of total revenues and another customer accounted for 10% of
total revenues.  For the year ended December 31, 2005, one customer
accounted for 17% of total revenues and another customer accounted for 15% of
total revenues.
 
 NOTE
17.  SUBSEQUENT EVENTS
 
 Through
March 31, 2008, the Company has issued 1,404,251,012 shares of its Class A
common stock in conversion of 16 shares of Series L Preferred
Stock.
 
 Through
March 31, 2008, the Company has issued 7,403,846 shares of its Class A common
stock in payment of interest on the Series L Preferred Stock.
 
  F-29
  Fonix
Corporation
and Subsidiaries
 Notes
to Consolidated Financial Statements
 
 Through
March 31, 2008, the Company has issued 53,913,701shares of its Class A common
stock in conversion of interest on the related party note.
 
 As
discussed above, in February 2008, the Company entered into an amended
settlement agreement with Breckenridge under which the Company agreed to pay
Breckenridge $540, 000.  The Company has paid Breckenridge $242,500
and is obligated to pay the balance of $297,500 at the rate of $42,500 per
month.
 
 Mr.
Murdock resigned as Chief Executive Officer, President, and Chairman of Fonix on
March 5, 2008.  Additionally, Mr. Maasberg resigned as a director on
March 5, 2008 and as Chief Operating Officer on March 31, 2008.
  Between
December 31, 2007 and March 31, 2008, the Company received an aggregate of
$250,000 from two investors in connection with an investment in the
Company.  The Company and the investors are negotiating the terms of the
investment, which will be disclosed once the terms have been finalized and
documents have been signed.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 F-30